ACCA Strategic Business Reporting Study Text 2021-2022 PDF

Valid for September 2021, ACCA (SBR-INT/UK) December 2021, March 2022 and June 2022 Exam-focused...

Valid for September 2021, ACCA (SBR-INT/UK) December 2021, March 2022 and June 2022 Exam-focused ACCA Kaplan’s vast classroom experience helps many students pass first time. The books are designed to cover the whole syllabus and they reflect how topics are taught in the classroom, focusing on what will be required of you in the exam. Strategic Student-friendly Using accessible language and engaging Business formats to help you understand more complex Reporting Reporting Strategic Business areas, Kaplan simplifies the learning process (SBR-INT/UK) to make it easier for you to succeed. Written by our expert tutors All Kaplan study materials are written by our subject specialists, experienced tutors who teach the paper so they know what works and June 2022 December 2021, March 2022 Valid for September 2021, for students and how best to deliver it. Innovative solutions More than just books, our study materials are supported by a wealth of free online resources, including testing and course assessments. All accessible from our online learning environment MyKaplan. All the resources have been designed to keep you on your study plan and help you pass first time. Kaplan Publishing UK Study Text ISBN 978-1-78740-867-8 Study Text 9 781787 408678  ACCA SBR Strategic Business Reporting Study Text  British Library Cataloguing‐in‐Publication Data A catalogue record for this book is available from the British Library. Published by: Kaplan Publishing UK Unit 2 The Business Centre Molly Millar’s Lane Wokingham Berkshire RG41 2QZ ISBN: 978-1-78740-867-8 © Kaplan Financial Limited, 2021 The text in this material and any others made available by any Kaplan Group company does not amount to advice on a particular matter and should not be taken as such. No reliance should be placed on the content as the basis for any investment or other decision or in connection with any advice given to third parties. Please consult your appropriate professional adviser as necessary. Kaplan Publishing Limited, all other Kaplan group companies, the International Accounting Standards Board, and the IFRS Foundation expressly disclaim all liability to any person in respect of any losses or other claims, whether direct, indirect, incidental, consequential or otherwise arising in relation to the use of such materials. Printed and bound in Great Britain. Acknowledgements These materials are reviewed by the ACCA examining team. The objective of the review is to ensure that the material properly covers the syllabus and study guide outcomes, used by the examining team in setting the exams, in the appropriate breadth and depth. The review does not ensure that every eventuality, combination or application of examinable topics is addressed by the ACCA Approved Content. Nor does the review comprise a detailed technical check of the content as the Approved Content Provider has its own quality assurance processes in place in this respect. This Product includes propriety content of the International Accounting Standards Board which is overseen by the IFRS Foundation, and is used with the express permission of the IFRS Foundation under licence. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior written permission of Kaplan Publishing and the IFRS Foundation. The IFRS Foundation logo, the IASB logo, the IFRS for SMEs logo, the “Hexagon Device”, “IFRS Foundation”, “eIFRS”, “IAS”, “IASB”, “IFRS for SMEs”, “IFRS”, “IASs”, “IFRSs”, “International Accounting Standards” and “International Financial Reporting Standards”, “IFRIC” and “IFRS Taxonomy” are Trade Marks of the IFRS Foundation. Trade Marks The IFRS Foundation logo, the IASB logo, the IFRS for SMEs logo, the “Hexagon Device”, “IFRS Foundation”, “eIFRS”, “IAS”, “IASB”, “IFRS for SMEs”, “NIIF” IASs” “IFRS”, “IFRSs”, “International Accounting Standards”, “International Financial Reporting Standards”, “IFRIC”, “SIC” and “IFRS Taxonomy”. Further details of the Trade Marks including details of countries where the Trade Marks are registered or applied for are available from the Foundation on request. P.2 KAPLAN PUBLISHING  Contents Page Chapter 1 Frameworks 1 Chapter 2 The professional and ethical duty of the accountant 27 Chapter 3 Performance reporting 37 Chapter 4 Revenue 57 Chapter 5 Non-current assets 79 Chapter 6 Agriculture and inventories 125 Chapter 7 Foreign currency in individual financial statements 135 Chapter 8 Leases 151 Chapter 9 Employee benefits 177 Chapter 10 Share-based payment 207 Chapter 11 Events after the reporting period, provisions and contingencies 233 Chapter 12 Financial instruments 253 Chapter 13 Tax 311 Chapter 14 Segment reporting 333 Chapter 15 Related parties 343 Chapter 16 Adopting new accounting standards 357 Chapter 17 Small and medium entities 365 Chapter 18 Group accounting – basic groups 371 Chapter 19 Change in a group structure 431 Chapter 20 Group accounting – foreign currency 471 Chapter 21 Group statement of cash flows 491 Chapter 22 Analysis and interpretation 535 Chapter 23 Current issues 573 KAPLAN PUBLISHING P.3  Chapter 24 UK GAAP 595 Chapter 25 Questions & Answers 617 Chapter 26 Employability and technology skills 651 Chapter 27 References 659 Index I.1 P.4 KAPLAN PUBLISHING  Introduction This document references IFRS® Standards and IAS® Standards, which are authored by the International Accounting Standards Board (the Board), and published in the 2020 IFRS Standards Red Book. KAPLAN PUBLISHING P.5  How to use the Materials Strategic Business Reporting is an exam at the Strategic Professional level of the ACCA qualification. It assumes knowledge acquired at the Fundamentals level including the core technical capabilities to prepare and analyse financial reports for single and combined entities These Kaplan Publishing learning materials have been carefully designed to make your learning experience as easy as possible and to give you the best chances of success in your examinations. The product range contains a number of features to help you in the study process. They include: 1 Detailed study guide and syllabus objectives 2 Description of the examination 3 Study skills and revision guidance 4 Study text 5 Question practice The sections on the study guide, the syllabus objectives, the examination and study skills should all be read before you commence your studies. They are designed to familiarise you with the nature and content of the examination and give you tips on how to best to approach your learning. The Study Text comprises the main learning materials and gives guidance as to the importance of topics and where other related resources can be found. Each chapter includes:  The learning objectives contained in each chapter, which have been carefully mapped to the examining body's own syllabus learning objectives or outcomes. You should use these to check you have a clear understanding of all the topics on which you might be assessed in the examination.  The chapter diagram provides a visual reference for the content in the chapter, giving an overview of the topics and how they link together.  The content for each topic area commences with a brief explanation or definition to put the topic into context before covering the topic in detail. You should follow your studying of the content with a review of the illustration/s. These are worked examples which will help you to understand better how to apply the content for the topic. P.6 KAPLAN PUBLISHING   Test your understanding sections provide an opportunity to assess your understanding of the key topics by applying what you have learned to short questions. Answers can be found at the back of each chapter.  Summary diagrams complete each chapter to show the important links between topics and the overall content of the paper. These diagrams should be used to check that you have covered and understood the core topics before moving on.  Question practice is provided through this text. Quality and accuracy are of the utmost importance to us so if you spot an error in any of our products, please send an email to [email protected] with full details, or follow the link to the feedback form in MyKaplan. Our Quality Coordinator will work with our technical team to verify the error and take action to ensure it is corrected in future editions. Icon Explanations Definition – Key definitions that you will need to learn from the core content. Key point – Identifies topics that are key to success and are often examined. Supplementary reading – These sections will help to provide a deeper understanding of core areas. The supplementary reading is NOT optional reading. It is vital to provide you with the breadth of knowledge you will need to address the wide range of topics within your syllabus that could feature in an exam question. Reference to this text is vital when self studying. Test your understanding – Exercises for you to complete to ensure that you have understood the topics just learned. Illustration – Worked examples help you understand the core content better. Tutorial note – Included to explain some of the technical points in more detail. Footsteps – Helpful tutor tips. KAPLAN PUBLISHING P.7  Links to other syllabus areas – This symbol refers to areas of interaction with other parts of your syllabus, either in terms of other ACCA papers that you have studied, or may go on to study, or even further professional qualifications that you may decide to pursue on completion of ACCA. On-line subscribers Our on-line resources are designed to increase the flexibility of your learning materials and provide you with immediate feedback on how your studies are progressing. If you are subscribed to our on-line resources you will find: 1 On-line referenceware: reproduces your Study Text on-line, giving you anytime, anywhere access. 2 On-line testing: provides you with additional on-line objective testing so you can practice what you have learned further. 3 On-line performance management: immediate access to your on-line testing results. Review your performance by key topics and chart your achievement through the course relative to your peer group. Ask your local customer services staff if you are not already a subscriber and wish to join. Paper introduction Paper background The Strategic Business Reporting (SBR) syllabus requires students to examine corporate reporting from a number of perspectives, not only from the point of view of the preparer of corporate reports, but also from the perspective of a variety of different stakeholders such as finance providers. The syllabus further requires the assessment and evaluation of the reporting decisions made by management and their implications for a range of stakeholders and entities. It also explores the professional and ethical responsibilities of the accountant to these stakeholders. Objectives of the syllabus Candidates should be able to:  Apply fundamental ethical and professional principles to ethical dilemmas and discuss the consequences of unethical behaviour  Evaluate the appropriateness of the financial reporting framework and critically discuss changes in accounting regulation  Apply professional judgement in the reporting of the financial performance of a range of entities  Prepare the financial statements of groups of entities  Interpret financial statements for different stakeholders  Communicate the impact of changes and potential changes in accounting regulation on financial reporting. P.8 KAPLAN PUBLISHING  Syllabus Core areas of the syllabus  Fundamental ethical and professional principles  The financial reporting framework  Reporting the financial performance of a range of entities  Financial statements of groups of entities  Interpret financial statements for different stakeholders  The impact of changes and potential changes in accounting regulation Approach to INT and UK syllabus elements The international syllabus has been used as the basis of this Study Text. The additional content required for those sitting the UK paper is in Chapter 24. The UK exam primarily tests International Financial Reporting Standards. The Examiner has indicated that part of one of the Section B questions in the UK paper will be adapted to assess UK specific content. This question may be based on either a single entity or a group and will be worth approximately 15-20 marks. It may have discursive and/or numerical content and requirements, and could cover the following syllabus areas:  The financial reporting requirements for UK and Republic of Ireland entities (UK GAAP) and their interaction with the Companies Act requirements  The reasons why an entity might choose to adopt FRS 101 or FRS 102  The scope and basis of preparation of financial statements under UK GAAP  The concepts and pervasive principles set out in FRS 102  The principal differences between UK GAAP and International Financial Reporting Standards. KAPLAN PUBLISHING P.9  ACCA Performance Objectives In order to become a member of the ACCA, as a trainee accountant you will need to demonstrate that you have achieved nine performance objectives. Performance objectives are indicators of effective performance and set the minimum standard of work that trainees are expected to achieve and demonstrate in the workplace. They are divided into key areas of knowledge which are closely linked to the exam syllabus. There are five Essential performance objectives and a choice of fifteen Technical performance objectives which are divided into five areas. The performance objectives which link to this exam are: 1 Ethics and professionalism (Essential) 2 Stakeholder relationship management (Essential) 3 Record and process transactions and events (Technical) 4 Prepare external financial reports (Technical) 5 Analyse and interpret financial reports (Technical) The following link provides an in depth insight into all of the performance objectives: https://www.accaglobal.com/content/dam/ACCA_Global/Students/per/PER- Performance-objectives-achieve.pdf P.10 KAPLAN PUBLISHING  Progression There are two elements of progression that we can measure: first how quickly students move through individual topics within a subject; and second how quickly they move from one course to the next. We know that there is an optimum for both, but it can vary from subject to subject and from student to student. However, using data and our experience of student performance over many years, we can make some generalisations. A fixed period of study set out at the start of a course with key milestones is important. This can be within a subject, for example ‘I will finish this topic by 30 June’, or for overall achievement, such as ‘I want to be qualified by the end of next year’. Your qualification is cumulative, as earlier papers provide a foundation for your subsequent studies, so do not allow there to be too big a gap between one subject and another. We know that exams encourage techniques that lead to some degree of short term retention, the result being that you will simply forget much of what you have already learned unless it is refreshed (look up Ebbinghaus Forgetting Curve for more details on this). This makes it more difficult as you move from one subject to another: not only will you have to learn the new subject, you will also have to relearn all the underpinning knowledge as well. This is very inefficient and slows down your overall progression which makes it more likely you may not succeed at all. In addition, delaying your studies slows your path to qualification which can have negative impacts on your career, postponing the opportunity to apply for higher level positions and therefore higher pay. You can use the following diagram showing the whole structure of your qualification to help you keep track of your progress. KAPLAN PUBLISHING P.11  Syllabus objectives We have reproduced the ACCA’s syllabus below: A FUNDAMENTAL ETHICAL AND PROFESSIONAL PRINCIPLES 1 Professional behaviour and compliance with accounting standards (a) Appraise and discuss the importance of ethical and professional behaviour in complying with accounting standards and corporate reporting requirements. (b) Assess and discuss the consequences of unethical behaviour by management in carrying out their responsibility for the preparation of corporate reports. B THE FINANCIAL REPORTING FRAMEWORK 1 The applications, strengths and weaknesses of an accounting framework (a) Discuss the importance of a conceptual framework in underpinning the production of accounting standards. (b) Discuss the objectives of financial reporting including disclosure of information that can be used to help assess management’s stewardship of the entity’s resources, and the limitations of financial reporting. (c) Discuss the nature of the qualitative characteristics of useful financial information. (d) Explain the roles of prudence and substance over form in financial reporting. (e) Discuss the high level measurement uncertainty that can make financial information less relevant. (f) Evaluate the decisions made by management on recognition, derecognition and measurement. (g) Critically discuss and apply the definitions of the elements of financial statements and the reporting of items in the statement of profit or loss and other comprehensive income. P.12 KAPLAN PUBLISHING  C REPORTING THE FINANCIAL PERFORMANCE OF A RANGE OF ENTITIES 1 Revenue (a) Discuss and apply the criteria that must be met before an entity can apply the revenue recognition model to a contract. (b) Discuss and apply the five step model which relates to revenue earned from a contract with a customer. (c) Apply the criteria for recognition of contract costs as an asset. (d) Discuss and apply the recognition and measurement of revenue including performance obligations satisfied over time, sale with a right of return, warranties, variable consideration, principal versus agent considerations and non-refundable up-front fees. 2 Non-current assets (a) Discuss and apply the recognition, derecognition and measurement of non-current assets including impairments and revaluations. (b) Discuss and apply the accounting requirements for the classification and measurement of non-current assets held for sale. (c) Discuss and apply the accounting treatment of investment properties including classification, recognition, measurement and change of use. (d) Discuss and apply the accounting treatment of intangible assets including the criteria for recognition and measurement subsequent to acquisition. (e) Discuss and apply the accounting treatment for borrowing costs. 3 Financial instruments (a) Discuss and apply the initial recognition and measurement of financial instruments. (b) Discuss and apply the subsequent measurement of financial assets and financial liabilities. (c) Discuss and apply the derecognition of financial assets and financial liabilities. (d) Discuss and apply the reclassification of financial assets. (e) Account for derivative financial instruments, and simple embedded derivatives. (f) Outline and apply the qualifying criteria for hedge accounting and account for fair value hedges and cash flow hedges including hedge effectiveness. (g) Discuss and apply the general approach to impairment of financial instruments including the basis for estimating expected credit losses. (h) Discuss the implications of a significant increase in credit risk. (i) Discuss and apply the treatment of purchased or originated credit impaired financial assets. KAPLAN PUBLISHING P.13  4 Leases (a) Discuss and apply the lessee accounting requirements for leases including the identification of a lease and the measurement of the right of use asset and liability. (b) Discuss and apply the accounting for leases by lessors. (c) Discuss and apply the circumstances where there may be re- measurement of the lease liability. (d) Discuss and apply the reasons behind the separation of the components of a lease contract into lease and non-lease elements. (e) Discuss the recognition exemptions under the current leasing standard. (f) Discuss and apply the principles behind accounting for sale and leaseback transactions. 5 Employee benefits (a) Discuss and apply the accounting treatment of short term and long term employee benefits, termination benefits, and defined contribution and defined benefit plans. (b) Account for gains and losses on settlements and curtailments. (c) Account for the ‘Asset Ceiling’ test and the reporting of actuarial gains and losses. 6 Income taxes (a) Discuss and apply the recognition and measurement of deferred tax liabilities and deferred tax assets. (b) Discuss and apply the recognition of current and deferred tax as income or expense. (c) Discuss and apply the treatment of deferred taxation on a business combination. 7 Provisions, contingencies, events after the reporting date (a) Discuss and apply the recognition, de-recognition and measurement of provisions, contingent liabilities and contingent assets including environmental provisions and restructuring provisions. (b) Discuss and apply the accounting for events after the reporting period. 8 Share-based payment (a) Discuss and apply the recognition and measurement of share-based payment transactions. (b) Account for modifications, cancellations and settlements of share-based payment transactions. P.14 KAPLAN PUBLISHING  9 Fair value measurement (a) Discuss and apply the definitions of ‘fair value’ measurement and ‘active market’. (b) Discuss and apply the ‘fair value hierarchy’. (c) Discuss and apply the principles of highest and best use, most advantageous and principal market. (d) Explain the circumstances where an entity may use a valuation technique. 10 Reporting requirements of small and medium-sized entities (SMEs) (a) Discuss the key differences in accounting treatment between full IFRS Standards and the IFRS for SMEs Standard. (b) Discuss and apply the simplifications introduced by the IFRS for SMEs Standard. 11 Other reporting issues (a) Discuss and apply the accounting for, and disclosure of, government grants and other forms of government assistance. (b) Outline the principles behind the application of accounting policies and measurement in interim reports. (c) Discuss and apply the judgements required in selecting and applying accounting policies, accounting for changes in estimates and reflecting corrections of prior period errors. (d) Identify related parties and assess the implications of related party relationships in the preparation of corporate reports. D FINANCIAL STATEMENTS OF GROUPS OF ENTITIES 1 Group accounting including statements of cash flow (a) Discuss and apply the principles behind determining whether a business combination has occurred. (b) Discuss and apply the method of accounting for a business combination including identifying an acquirer and the principles in determining the cost of a business combination. (c) Apply the recognition and measurement criteria for identifiable acquired assets and liabilities including contingent amounts and intangible assets. (d) Discuss and apply the accounting for goodwill and non-controlling interest. (e) Apply the accounting principles relating to a business combination achieved in stages. (f) Discuss and apply the application of the control principle. (g) Determine and apply appropriate procedures to be used in preparing consolidated financial statements. KAPLAN PUBLISHING P.15  (h) Discuss and apply the implications of changes in ownership interest and loss of control. (i) Prepare group financial statements where activities have been discontinued, or have been acquired or disposed of in the period. (j) Discuss and apply the treatment of a subsidiary which has been acquired exclusively with a view to subsequent disposal. (k) Identify and outline the circumstances in which a group is required to prepare consolidated financial statements; the circumstances when a group may claim an exemption from the preparation of consolidated financial statements, and why directors may not wish to consolidate a subsidiary and where this is permitted. (l) Prepare and discuss group statements of cash flows. 2 Associates and joint arrangement (a) Identify associate entities. (b) Discuss and apply the equity method of accounting for associates. (c) Apply the method of accounting for associates. (d) Discuss and apply the application of the joint control principle. (e) Discuss and apply the classification of joint arrangements. (f) Prepare the financial statements of parties to the joint arrangement. 3 Changes in group structures (a) Discuss and apply accounting for group companies in the separate financial statements of the parent company. (b) Apply the accounting principles where the parent reorganises the structure of the group by establishing a new entity or changing the parent. 4 Foreign transactions and entities (a) Outline and apply the translation of foreign currency amounts and transactions into the functional currency and the presentational currency. (b) Account for the consolidation of foreign operations and their disposal. E INTERPRET FINANCIAL STATEMENTS FOR DIFFERENT STAKEHOLDERS 1 Analysis and interpretation of financial information and measurement of performance (a) Discuss and apply relevant indicators of financial and non-financial performance including earnings per share and additional performance measures. (b) Discuss the increased demand for transparency in corporate reports, and the emergence of non-financial reporting standards. P.16 KAPLAN PUBLISHING  (c) Appraise the impact of environmental, social, and ethical factors on additional performance measures. (d) Discuss how sustainability reporting is evolving and the importance of effective sustainability reporting. (e) Discuss how integrated reporting improves the understanding of the relationship between financial and non-financial performance and of how a company creates sustainable value. (f) Determine the nature and extent of reportable segments. (g) Discuss the nature of segment information to be disclosed and how segmental information enhances the quality and sustainability of performance. F THE IMPACT OF CHANGES AND POTENTIAL CHANGES IN ACCOUNTING REGULATION 1 Discussion of solutions to current issues in financial reporting (a) Discuss and apply the accounting implications of the first time adoption of new accounting standards. (b) Identify issues and deficiencies which have led to proposed changes to an accounting standard. (c) Discuss the impact of current issues in corporate reporting. This learning outcome may be tested by requiring the application of one or several existing standards to an accounting issue. It is also likely to require an explanation of the resulting accounting implications (for example, accounting for digital assets or accounting for the effects of a natural disaster or global event). The following examples are relevant to the current syllabus: – Presentation and disclosures – Materiality in the context of financial reporting – Management commentary (d) Discuss developments in devising a structure for corporate reporting that addresses the needs of stakeholders. G EMPLOYABILITY AND TECHNOLOGY SKILLS 1 Use computer technology to efficiently access and manipulate relevant information. 2 Work on relevant response options, using available functions and technology, as would be required in the workplace. 3 Navigate windows and computer screens to create and amend responses to exam requirements using the appropriate tools. 4 Present data and information effectively, using the appropriate tools. KAPLAN PUBLISHING P.17  The superscript numbers in square brackets indicate the intellectual depth at which the subject area could be assessed within the examination. Level 1 (knowledge and comprehension) broadly equates with the Knowledge module, Level 2 (application and analysis) with the Skills module and Level 3 (synthesis and evaluation) to the Professional level. However, lower level skills can continue to be assessed as you progress through each module and level. The examination Examination format The syllabus is assessed by a three-hour fifteen minute examination. It examines professional competences within the business reporting environment. Students will be examined on concepts, theories, and principles, and on their ability to question and comment on proposed accounting treatments. Students should be capable of relating professional issues to relevant concepts and practical situations. The evaluation of alternative accounting practices and the identification and prioritisation of issues will be a key element of the exam. Professional and ethical judgement will need to be exercised, together with the integration of technical knowledge when addressing business reporting issues in a business context. Students will be required to adopt either a stakeholder or an external focus in answering questions and to demonstrate personal skills such as problem solving, dealing with information and decision making. Students will have to demonstrate communication skills appropriate to the scenario. The paper also deals with specific professional knowledge appropriate to the preparation and presentation of consolidated and other financial statements from accounting data, to conform with accounting standards. The paper will comprise two sections: Section A consists of two scenario based questions that will total 50 marks. The first question, worth 30 marks, will be based on the financial statements of group entities, or extracts thereof, and is also likely to require consideration of some financial reporting issues. Candidates should understand that in addition to the consideration of the numerical aspects of group accounting (max 25 marks), a discussion and explanation of these numbers will also be required. The second question, worth 20 marks, will require candidates to consider (i) the reporting implications and (ii) the ethical implications of specific events in a given scenario. Two professional marks will be awarded in the ethical issues question in Section A Section B consists of two questions, which may be scenario or case-study or essay based and will contain both discursive and computational elements. Section B could deal with any aspect of the syllabus but will always include either a full question, or part of a question, that tests the analysis part of the syllabus. P.18 KAPLAN PUBLISHING  Two professional marks will be awarded in the Section B question that requires analysis. UK syllabus students sit an exam that is identical in format to the International syllabus exam. ACCA has indicated that parts of Section B questions in the UK paper will be adapted to assess UK specific content for approximately 15-20 marks. Number of marks Section A Two compulsory questions totalling 50 marks 50 Section B Two compulsory questions of 25 marks each 50 ––– Total time allowed: 3 hours and 15 minutes 100 Strategic Professional CBE From March 2020, ACCA introduced Strategic Professional computer based examinations (CBE) in selected locations. Strategic Professional CBE will be extended to other locations over time, across subsequent examination sessions. Once CBE are offered in a location, the paper-based exam will no longer be available. For more information regarding when Strategic Professional CBE will be introduced in your market, please refer to the ACCA Global website. This Study Text is appropriate for both CBE and paper-based exams. It is essential that students who will be sitting the CBE become familiar with the CBE environment as part of their exam preparation. For additional support please refer to the ACCA Global website. Study skills and revision guidance This section aims to give guidance on how to study for your ACCA exams and to give ideas on how to improve your existing study techniques. Preparing to study Set your objectives Before starting to study decide what you want to achieve – the type of pass you wish to obtain. This will decide the level of commitment and time you need to dedicate to your studies. Devise a study plan Determine which times of the week you will study. Split these times into sessions of at least one hour for study of new material. Any shorter periods could be used for revision or practice. KAPLAN PUBLISHING P.19  Put the times you plan to study onto a study plan for the weeks from now until the exam and set yourself targets for each period of study – in your sessions make sure you cover the course, course assignments and revision. If you are studying for more than one paper at a time, try to vary your subjects as this can help you to keep interested and see subjects as part of wider knowledge. When working through your course, compare your progress with your plan and, if necessary, re-plan your work (perhaps including extra sessions) or, if you are ahead, do some extra revision/practice questions. Effective studying Active reading You are not expected to learn the text by rote, rather, you must understand what you are reading and be able to use it to pass the exam and develop good practice. A good technique to use is SQ3Rs – Survey, Question, Read, Recall, Review: (1) Survey the chapter – look at the headings and read the introduction, summary and objectives, so as to get an overview of what the chapter deals with. (2) Question – whilst undertaking the survey, ask yourself the questions that you hope the chapter will answer for you. (3) Read through the chapter thoroughly, answering the questions and making sure you can meet the objectives. Attempt the exercises and activities in the text, and work through all the examples. (4) Recall – at the end of each section and at the end of the chapter, try to recall the main ideas of the section/chapter without referring to the text. This is best done after a short break of a couple of minutes after the reading stage. (5) Review – check that your recall notes are correct. You may also find it helpful to re-read the chapter to try to see the topic(s) it deals with as a whole. Note-taking Taking notes is a useful way of learning, but do not simply copy out the text. The notes must:  be in your own words  be concise  cover the key points  be well-organised  be modified as you study further chapters in this text or in related ones. Trying to summarise a chapter without referring to the text can be a useful way of determining which areas you know and which you don't. P.20 KAPLAN PUBLISHING  Three ways of taking notes: Summarise the key points of a chapter. Make linear notes – a list of headings, divided up with subheadings listing the key points. If you use linear notes, you can use different colours to highlight key points and keep topic areas together. Use plenty of space to make your notes easy to use. Try a diagrammatic form – the most common of which is a mind-map. To make a mind-map, put the main heading in the centre of the paper and put a circle around it. Then draw short lines radiating from this to the main sub- headings, which again have circles around them. Then continue the process from the sub-headings to sub-sub-headings, advantages, disadvantages, etc. Highlighting and underlining – you may find it useful to underline or highlight key points in your study text, but do be selective. You may also wish to make notes in the margins. Revision The best approach to revision is to revise the course as you work through it. Also try to leave four to six weeks before the exam for final revision. Make sure you cover the whole syllabus and pay special attention to those areas where your knowledge is weak. Here are some recommendations: Read through the text and your notes again and condense your notes into key phrases. It may help to put key revision points onto index cards to look at when you have a few minutes to spare. Review any assignments you have completed and look at where you lost marks – put more work into those areas where you were weak. The SBR examining team produce detailed marking guides at the end of the solutions to past exam questions. These are available in the Exam Kit. Practise exam standard questions under timed conditions. If you are short of time, list the points that you would cover in your answer and then read the model answer, but do try to complete at least a few questions under exam conditions. Make sure that you read the ACCA article, ‘What is the Examiner Asking?’ This will help you to ensure that you fully understand what is required of you in the exam. It can be found here: https://www.accaglobal.com/uk/en/student/sa/study-skills/questions.html Also practise producing answer plans and comparing them to the model answer. If you are stuck on a topic find somebody (a tutor) to explain it to you. Read good newspapers and professional journals, especially ACCA's Student Accountant – this can give you an advantage in the exam. Ensure you know the structure of the exam – how many questions there are, what types of question you will be expected to answer, and the time you will spend on each question. During your revision attempt all the different styles of questions you may be asked. KAPLAN PUBLISHING P.21  Further reading The examining team have stated the need for students to read widely. Technical articles relevant to SBR can be found on the ACCA website at the following address: https://www.accaglobal.com/uk/en/student/exam-support- resources/professional-exams-study-resources/strategic-business- reporting/technical-articles.html Please be aware that ACCA update their list of examinable documents annually. You should refer to this before undertaking any further reading. P.22 KAPLAN PUBLISHING Chapter 1 Frameworks Chapter learning objectives Upon completion of this chapter you will be able to:  Discuss the importance of a conceptual framework in underpinning the production of accounting standards  Discuss the objectives of financial reporting including disclosure of information that can be used to help assess management’s stewardship of the entity’s resources and the limitations of financial reporting  Discuss the nature of the qualitative characteristics of useful financial information  Explain the roles of prudence and substance over form in financial reporting  Discuss the high level measurement uncertainty that can make financial information less relevant  Evaluate the decisions made by management on recognition, derecognition and measurement  Critically discuss and apply the definitions of the elements of financial statements  Discuss and apply the definitions of ‘fair value’ measurement and ‘active market'  Discuss and apply the ‘fair value hierarchy’  Discuss and apply the principles of highest and best use, most advantageous and principal market  Explain the circumstances where an entity may use a valuation technique. KAPLAN PUBLISHING 1 Frameworks One of the PER performance objectives (PO7) is to prepare external financial reports. You take part in preparing and reviewing financial statements – and all accompanying information – and you do it in accordance with legal and PER regulatory requirements. Working through this chapter should help you understand how to demonstrate that objective. 2 KAPLAN PUBLISHING  Chapter 1 1 Introduction This chapter considers two documents issued by the International Accounting Standards Board (the Board) that underpin a range of IFRS and IAS Standards:  The Conceptual Framework for Financial Reporting – used by the Board when developing or revising an IFRS or IAS Standard, and by preparers of financial statements when no relevant IFRS or IAS Standard exists, and  IFRS 13 Fair Value Measurement – used by preparers of financial statements when an IFRS or IAS Standard requires or allows the use of a fair value measurement (with some exceptions). Progression You will have seen the content of this chapter in your prior studies. However, the ACCA SBR exam will test it at a much higher level. 2 Conceptual Framework for Financial Reporting Introduction The importance of a conceptual framework A conceptual framework is a set of theoretical principles and concepts that underlie the preparation and presentation of financial statements. If no conceptual framework existed, then accounting standards would be produced on a haphazard basis as particular issues and circumstances arose. These accounting standards might be inconsistent with one another, or perhaps even contradictory. A strong conceptual framework means that there are principles in place from which all future accounting standards draw. It also acts as a reference point for the preparers of financial statements if no accounting standard governs a particular transaction (although this will be extremely rare). This section of the text considers the contents of the Conceptual Framework for Financial Reporting (Conceptual Framework) in more detail. KAPLAN PUBLISHING 3 Frameworks Background The Framework for the Presentation and Preparation of Financial Statements was issued in 1989. In 2004 the Board and the US Financial Accounting Standards Board (FASB) started a joint project to revise their respective frameworks. As a result of this project the Board issued the Conceptual Framework for Financial Reporting in 2010. Most of the text from the 1989 Framework was simply rolled over but two chapters were revised. These covered:  The objective of financial reporting  The qualitative characteristics of useful financial information. The Board and the FASB subsequently suspended work on this joint project. Several criticisms emerged of the 2010 Conceptual Framework  It did not cover certain areas, such as derecognition, and presentation and disclosure  Guidance in some areas was unclear, such as with regards to measurement uncertainty  Some aspects were out of date, such as recognition criteria for assets and liabilities. As a result of criticism, the Conceptual Framework was identified as a priority project so, in 2012, the Board restarted this project without the FASB. A Discussion Paper outlining the Board’s thinking was published in 2013 and an Exposure Draft of the proposed amendments was published in 2015. Feedback from these documents informed the revised Conceptual Framework, which was published in 2018. The purpose of the Conceptual Framework The purpose of the Conceptual Framework is to assist: (a) the Board when developing new IFRS Standards, helping to ensure that these are based on consistent concepts (b) preparers of financial statements when no IFRS Standard applies to a particular transaction, or when an IFRS Standard offers a choice of accounting policy (c) all parties when understanding and interpreting IFRS Standards. The Conceptual Framework is not an accounting standard. It does not override the requirements in a particular IFRS Standard. The objective of financial reporting The Conceptual Framework states that the purpose of financial reporting is to provide information to current and potential investors, lenders and other creditors that will enable them to make decisions about providing economic resources to an entity. 4 KAPLAN PUBLISHING  Chapter 1 If investors, lenders and creditors are going to make these decisions then they require information that will help them to assess:  an entity’s potential future cash flows, and  management’s stewardship of the entity’s economic resources. To assess an entity’s future cash flows, users need information about:  economic resources of the entity e.g. assets  economic claims against the entity e.g. liabilities and equity  changes in economic resources and claims e.g. income and expenses. Summary of the content of the Conceptual Framework KAPLAN PUBLISHING 5 Frameworks Qualitative characteristics of useful financial information Fundamental characteristics The Conceptual Framework states that financial information is only useful if it is:  relevant  a faithful representation of an entity’s transactions. Relevance and faithful representation are the fundamental characteristics of useful financial information. 1 Relevance Relevant information will make an impact on the decisions made by users of the financial statements. Relevance requires management to consider materiality. An item is material if omitting, misstating or obscuring it would influence the economic decisions of users. 2 Faithful representation A faithful representation of a transaction would represent its economic substance rather than its legal form. A perfectly faithful representation would be:  complete  neutral  free from error. The Board note that this is not fully achievable, but that these qualities should be maximised. When preparing financial reports, preparers should exercise prudence. Prudence means that assets and income are not overstated and liabilities and expenses are not understated. However, this does not mean that assets and income should be purposefully understated, or liabilities and expenses purposefully overstated. Such intentional misstatements are not neutral. Enhancing characteristics In addition to the two fundamental qualitative characteristics, there are four enhancing qualitative characteristics of useful financial information:  Comparability – investors should be able to compare an entity’s financial information year-on-year, and one entity’s financial information with another.  Timeliness – older information is less useful.  Verifiability – knowledgeable users should be able to agree that a particular depiction of a transaction offers a faithful representation.  Understandability – information should be presented as clearly and concisely as possible. 6 KAPLAN PUBLISHING  Chapter 1 Cost constraint Producing financial reports takes time and costs money. When developing IFRS Standards, the Board assesses whether the benefits of reporting particular information outweigh the costs involved in providing it. Cost constraint – an example IFRS 16 Leases, which replaced IAS 17 Leases, radically changed lessee accounting by requiring all lessees to recognise an asset and liability at the inception of a lease (unless the lease is short-term or of minimal value). However, IFRS 16 did not change the accounting treatment of leases by lessors. This was because most stakeholders did not believe that the requirements relating to lessors in IAS 17 were ‘broken’. The perceived time and costs involved in implementing substantial changes to lessor accounting was therefore believed to outweigh any benefits. Financial statements and the reporting entity Financial statements The Conceptual Framework notes that financial statements are a particular type of financial report. The purpose of financial statements is to provide information to users about an entity’s:  assets  liabilities  equity  income  expenses. This information is provided in:  a statement of financial position  statements of financial performance  other statements, such as statements of cash flows and notes. Financial statements are prepared on the assumption that the entity is a going concern. This means that it will continue to operate for the foreseeable future. If this assumption is not accurate, then the financial statements should be prepared on a different basis. KAPLAN PUBLISHING 7 Frameworks The reporting entity A reporting entity is one that prepares financial statements (either through choice, or as a result of legal requirements). Financial statements produced for two or more entities that are not parent/subsidiaries are called ‘combined financial statements’. It can be difficult in these circumstances to determine the boundary of the reporting entity. Note that the Conceptual Framework does not stipulate how or when to prepare combined financial statements, although the Board may develop a standard on this issue in the future. Financial statements produced for a reporting entity that comprises a parent company and its subsidiaries are called ‘consolidated financial statements’. These financial statements show the parent and its subsidiaries as a single economic entity. This information is important for investors in the parent because their economic returns are dependent on distributions from the subsidiary to the parent. Unconsolidated financial statements also provide useful information to investors in a parent company (for example, about the level of distributable reserves) but they are not a substitute for information provided in consolidated financial statements. The elements of financial statements The elements are the building blocks of financial statements:  statements of financial position report assets, liabilities and equity  statements of financial performance report income and expenses. Economic resource Asset ‘A present economic resource controlled by an entity as a result of a past event’ (para 4.3). Economic claim Liability ‘A present obligation of the entity to transfer an economic resource as a result of a past event’ (para 4.26). Equity The residual interest in the net assets of an entity. 8 KAPLAN PUBLISHING  Chapter 1 Changes in economic Income Increases in assets or resources and claims as a decreases in liabilities that result of financial result in an increase to performance equity (excluding contributions from equity holders). Expenses Decreases in assets or increases in liabilities that result in decreases to equity (excluding distributions to equity holders). Other changes in Contributions from, and economic resources and distributions to, equity claims holders. Exchanges of assets and liabilities that do not increase or decrease equity. An economic resource is a ‘right that has the potential to produce economic benefits’ (para 4.4). Recognition and derecognition Recognition Items are only recognised in the financial statements if they meet the definition of one of the elements. However, not all items meeting these definitions are recognised. Elements are recognised if recognition provides users with useful financial information. In other words recognition must provide:  relevant information  a faithful representation of the asset or liability, and resulting income, expenses or equity movements. Recognition might not provide relevant information if there is uncertainty over the existence of the element or if there is a low probability of an inflow or outflow of economic resources. Recognition – an example IAS 37 Provisions, Contingent Liabilities and Contingent Assets prohibits recognition of contingent liabilities and assets because it is not probable that resources will flow from or to the reporting entity. KAPLAN PUBLISHING 9 Frameworks Recognition of an element might not provide a faithful representation if there is a very high degree of measurement uncertainty. Judgement is required in deciding if recognition of an element is appropriate. This is why specific recognition criteria vary from one IFRS Standard to another. If an asset or liability is not recognised, disclosures may be required to ensure users fully understand the reporting entity’s economic transactions and the implications that these may have on future earnings and future cash flows. Test your understanding 1 – Bottle Bottle operates in the publishing industry. The Bottle brand is highly respected and, as a result, the books published by Bottle receive extensive coverage both online and in national and international press. The brand is internally generated and, in accordance with IAS 38 Intangible Assets, is not recognised in Bottle’s financial statements. Required: Discuss the extent to which the accounting treatment of the Bottle brand is consistent with the Conceptual Framework. Derecognition Derecognition is the removal of some or all of an asset or liability from the statement of financial position. This normally occurs when the entity:  loses control of the asset, or  has no present obligation for the liability. Accounting for derecognition should faithfully represent the changes in an entity’s net assets, as well as any assets or liabilities retained. This is achieved by:  derecognising any transferred, expired or consumed component  recognising a gain or loss on the above, and  recognising any retained component. Sometimes an entity might appear to have transferred an asset or liability. However, derecognition would not be appropriate if exposure to variations in the element’s economic benefits is retained. 10 KAPLAN PUBLISHING  Chapter 1 Derecognition – an example An entity sells a building for $2 million and retains the right to buy it back for $3 million in five years’ time. At the date of sale, the building had a fair value of $7 million. Property prices are expected to rise. The entity does not derecognise the building from its statement of financial position. The entity has not lost control over the building because its ability to buy the building back for substantially less than fair value enables it to benefit from future price rises. The cash received would be recognised as a loan liability. Measurement When recognised in the financial statements, elements must be quantified in monetary terms. The Conceptual Framework outlines two broad measurement bases:  Historical cost  Current value (this includes fair value, value-in-use, and current cost). Selecting a measurement base The information provided to users by the measurement base must be useful. In other words it must be relevant and offer a faithful representation of the transactions that have occurred. When selecting a measurement basis, the Conceptual Framework states that relevance is maximised if the following are considered:  The characteristics of the asset and/or liability  The ways in which the asset and/or liability contribute to future cash flows. This applies to the Board when developing or revising an IFRS Standard. It also applies to preparers of financial statements when applying an IFRS Standard that permits a choice of measurement bases. Selecting a measurement basis – an example Mist purchases an investment property in a prime location. Property prices are increasing in this area. As such, the value of the property is susceptible to market factors, and could substantially differ from the initial purchase price paid by Mist. KAPLAN PUBLISHING 11 Frameworks IAS 40 Investment Property offers a choice of accounting policy. Mist might choose:  The fair value model if they intend to sell the asset because this most faithfully represents the future cash flows they will receive from its eventual disposal  The cost model if they have no intention of selling the property because this best matches the rental income generated with the cost of the asset. Note that Mist might have no intention of selling the asset but still conclude that the fair value model provides the most relevant information about the building to financial statement users. This might be because increases in property prices will enable Mist to charge higher rents to its tenants, thus contributing to greater net cash inflows. Presentation and disclosure Effective presentation and disclosure Effective presentation and disclosure is a balance between allowing entities to flexibly report relevant information about their financial performance and position, and requiring information that enables comparisons to be drawn year- on-year and with other entities. The Board believes that:  entity specific information is more useful than standardised descriptions  duplication makes financial information less understandable. Classification Classification of an asset or liability into separate components may provide relevant information if the components have different characteristics. Classification – an example At the reporting date, Bottled owed $10 million to a bank. $1 million of this loan is due for repayment within 12 months and is presented as a current liability. The remaining $9 million is presented as a non-current liability. Classifying the liability in this way provides additional information to users, which helps them to assess Bottled’s future cash flows, as well as its solvency. Offsetting classifies dissimilar items together and is therefore generally not appropriate. 12 KAPLAN PUBLISHING  Chapter 1 Classification – an example Ellipsis has $3 million in an account held with Animal Bank. This money earns 1% interest per year. The balance is presented in Ellipsis’ statement of financial position as a current asset. Ellipsis also has a $1 million overdraft in an account held with Sotoro Bank. This incurs an interest charge of 10% a year. This overdraft is presented in Ellipsis’ statement of financial position as a current liability. Ellipsis must not offset its $3 million cash balance with its $1 million overdraft e.g. it cannot show a net $2 million current asset. The cash balance and the overdraft have different characteristics and risks, and offsetting would obscure these differences. Separate classification provides relevant information to the users of the financial statements. Aggregation Aggregation refers to the adding together of items that have shared characteristics. Aggregation is useful because it summarises information that would otherwise be too detailed. However, too much aggregation obscures relevant information. Different levels of aggregation will be required throughout the financial statements. For example, the statement of profit or loss may be heavily aggregated, but accompanying disclosure notes will disaggregate the information. Profit or loss and other comprehensive income The Conceptual Framework states that the statement of profit or loss is the primary source of information about an entity’s financial performance. As such, income and expenses should normally be recognised in this statement. When developing or revising standards, the Board notes that it might require an income or expense to be presented in other comprehensive income if it results from remeasuring an item to current value and if this means that:  profit or loss provides more relevant information, or  a more faithful representation is provided of an entity’s performance. Income and expenditure included in other comprehensive income should be reclassified to profit or loss when doing so results in profit or loss providing more relevant information. However, the Board may decide that reclassification is not appropriate if there is no clear basis for identifying the amount or timing of the reclassification. KAPLAN PUBLISHING 13 Frameworks Other comprehensive income – an example Entity A owns land and buildings that are accounted for using the revaluation model in IAS 16 Property, Plant and Equipment. At the reporting date, Entity A revalued these assets from $250 million to $300 million. IAS 16 stipulates that the $50 million gain must be recognised in other comprehensive income. Property, plant and equipment is not held for trading, but is instead used over more than one period to produce, supply, store and distribute goods. Including this $50 million gain in profit or loss would not offer a faithful representation of Entity A’s financial performance during the period. Test your understanding 2 – Cryptocurrencies Cryptocurrencies are digital currencies that operate independently of a central bank. Some businesses now accept cryptocurrencies in place of traditional currencies. The market price of cryptocurrency is highly volatile. Investors can earn large returns by buying cryptocurrency on an exchange when the quoted price is low and selling on an exchange when the quoted price rises. Cryptocurrencies have proved problematic with regards to financial reporting because they do not seem to fall within the scope of an issued IFRS or IAS Standard. As such, preparers of financial statements must use the Conceptual Framework to devise an accounting treatment that provides useful information to financial statement users. Required: Using the Conceptual Framework, discuss how an entity might account for an investment in cryptocurrency that it holds to trade. Criticisms of financial reporting The Conceptual Framework provides a principles-based approach to financial reporting. However, users are increasingly critical of the very nature of financial reporting. As a result, new forms of non-financial reporting have emerged, which are discussed later in this text. Some of the criticisms of financial reporting are discussed below. Historical information The statement of profit or loss shows the performance of the entity over the past reporting period. However, investors are more interested in future profits. Moreover by the time financial statements are published, the information presented will be several months out of date. 14 KAPLAN PUBLISHING  Chapter 1 Unrecognised assets and liabilities Some assets and liabilities are not recognised in financial statements prepared using IFRS Standards, such as internally generated goodwill. A company’s reputation and its employee’s skills play a pivotal role in its success but these are unrepresented on the statement of financial position. Clutter Financial reports have been criticised in recent years for becoming increasingly cluttered as a result of extensive disclosure requirements. These disclosures can be very generic and they make it harder for the users to find relevant information. Financial/non-financial information Current and past profits and cash flows are not the only determinate of future success. Long-term success is also dependent on how an entity is governed, the risks to which it is exposed and how well these are managed, and whether its business activities are sustainable into the medium and long-term. Financial statements prepared in accordance with IFRS Standards say little about these areas. Estimates Financial reporting uses many estimates (e.g. depreciation rates). Estimates are subjective and could be manipulated in order to achieve particular profit targets. The subjective nature of estimates reduces comparability between companies. The statement of cash flows somewhat compensates for the impact of accounting estimates. However, the cash position of an entity can also be window-dressed (such as by delaying payments to suppliers). Professional judgement Financial reporting requires judgement. For example, judgement is required by lessors when classifying a lease as a finance lease or an operating lease. Subjective decisions reduce comparability and increase the risk of bias. Use of historical cost Some accounting standards, such as IAS 16 Property, Plant and Equipment, permit assets to be measured at historical cost. In times of rising prices, the statement of profit or loss will not show a sustainable level of profit. Policy choices Some standards, such as IAS 16 Property, Plant and Equipment and IAS 40 Investment Properties, allow entities to choose between cost and fair value models. This makes it harder to investors to compare financial statements on a like-for-like basis. KAPLAN PUBLISHING 15 Frameworks 3 IFRS 13 Fair Value Measurement Introduction The objective of IFRS 13 is to provide a single source of guidance for fair value measurement where it is required by a reporting standard, rather than it being spread throughout several reporting standards. Many accounting standards require or allow items to be measured at fair value. Some examples from your prior studies include:  IAS 16 Property, Plant and Equipment, which allows entities to measure property, plant and equipment at fair value  IFRS 3 Business Combinations, which requires the identifiable net assets of a subsidiary to be measured at fair value at the acquisition date. Scope IFRS 13 does not apply to:  share-based payment transactions (IFRS 2 Share-based Payments)  leases (IFRS 16 Leases). The definition of fair value Fair value is defined as 'the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date' (IFRS 13, para 9). Market participants are knowledgeable, third parties. When pricing an asset or a liability, they would take into account:  Condition  Location  Restrictions on use. It should be assumed that market participants are not forced into transactions (i.e. they are not suffering from cash flow shortages). IFRS 13 notes that there are various approaches to determining the fair value of an asset or liability:  Market approaches (valuations based on recent sales prices)  Cost approaches (valuations based on replacement cost)  Income approaches (valuations based on financial forecasts). Whatever approach is taken, the aim is always the same – to estimate the price that would be transferred in a transaction with a market participant. 16 KAPLAN PUBLISHING  Chapter 1 The price Fair value is a market-based measurement, not one that is entity specific. As such, when determining the price at which an asset would be sold (or the price paid to transfer a liability), observable data from active markets should be used where possible. An active market is a market where transactions for the asset or liability occur frequently. IFRS 13 classifies inputs into valuation techniques into three levels.  Level 1 inputs are quoted prices for identical assets in active markets.  Level 2 inputs are observable prices that are not level 1 inputs. This may include: – Quoted prices for similar assets in active markets – Quoted prices for identical assets in less active markets – Observable inputs that are not prices (such as interest rates).  Level 3 inputs are unobservable. This could include cash or profit forecasts using an entity’s own data. A significant adjustment to a level 2 input would lead to it being categorised as a level 3 input. Priority is given to level 1 inputs. The lowest priority is given to level 3 inputs. Inputs to determine fair value IFRS 13 gives the following examples of inputs used to determine fair value: Asset Example Level 1 Equity shares in a Unadjusted quoted prices in an listed entity active market. Level 2 Building held and Price per square metre for the used building from observable market data, such as observed transactions for similar buildings in similar locations. Level 3 Cash-generating unit Profit or cash flow forecast using own data. KAPLAN PUBLISHING 17 Frameworks Test your understanding 3 – Baklava Baklava has an investment property that is measured at fair value. This property is rented out on short-term leases. The directors wish to fair value the property by estimating the present value of the net cash flows that the property will generate for Baklava. They argue that this best reflects the way in which the building will generate economic benefits for Baklava. The building is unique, although there have been many sales of similar buildings in the local area. Required: Discuss whether the valuation technique suggested by the directors complies with International Financial Reporting Standards. Markets The price received when an asset is sold (or paid when a liability is transferred) may differ depending on the specific market where the transaction occurs. Principal market IFRS 13 says that fair value should be measured by reference to the principal market. The principal market is the market with the greatest activity for the asset or liability being measured. The entity must be able to access the principal market at the measurement date. This means that the principal market for the same asset can differ between entities. Most advantageous market If there is no principal market, then fair value is measured by reference to prices in the most advantageous market. The most advantageous market is the one that maximises the net amount received from selling an asset (or minimises the amount paid to transfer a liability). Transaction costs (such as legal and broker fees) will play a role in deciding which market is most advantageous. However, fair value is not adjusted for transaction costs because they are a characteristic of the market, rather than the asset. 18 KAPLAN PUBLISHING  Chapter 1 Test your understanding 4 – Markets An asset is sold in two different active markets at different prices. An entity enters into transactions in both markets and can access the price in those markets for the asset at the measurement date as follows: Market 1 Market 2 $ $ Price 26 25 Transaction costs (3) (1) Transport costs (2) (2) –––– –––– Net price received 21 22 –––– –––– What is the fair value of the asset if: (a) market 1 is the principal market for the asset? (b) no principal market can be determined? Non-financial assets What is a non-financial asset? The difference between financial and non-financial assets is covered in detail in Chapter 12. Financial assets include:  Contractual rights to receive cash (such as receivables)  Investments in equity shares. Non-financial assets include:  Property, plant and equipment  Intangible assets. The fair value of a non-financial asset IFRS 13 says that the fair value of a non-financial asset should be based on its highest and best use. The highest and best use of an asset is the use that a market participant would adopt in order to maximise its value. The current use of a non-financial asset can be assumed to be the highest and best use, unless evidence exists to the contrary. The highest and best use should take into account uses that are:  physically possible  legally permissible  financially feasible. IFRS 13 says a use can be legally permissible even if it is not legally approved. KAPLAN PUBLISHING 19 Frameworks Test your understanding 5 – Five Quarters Five Quarters has purchased 100% of the ordinary shares of Three Halves and is trying to determine the fair value of the net assets at the acquisition date. Three Halves owns land that is currently developed for industrial use. The fair value of the land if used in a manufacturing operation is $5 million. Many nearby plots of land have been developed for residential use (as high-rise apartment buildings). The land owned by Three Halves does not have planning permission for residential use, although permission has been granted for similar plots of land. The fair value of Three Halves’ land as a vacant site for residential development is $6 million. However, transformation costs of $0.3 million would need to be incurred to get the land into this condition. Required: How should the fair value of the land be determined? Investor perspective Below is an extract from a disclosure note about the fair value of an entity’s financial assets and liabilities: Fair value of financial instruments Level 1 Level 2 Level 3 $m $m $m Financial asset – traded equities 110 – – Financial liability – contingent consideration – – 33 The fair values of the traded equities have been determined by reference to market price quotations. The fair value of contingent consideration is estimated based on the forecast future performance of the acquired business over a timeframe determined as part of the acquisition agreement, discounted as appropriate. Key assumptions include growth rates, expected selling volumes and prices and direct costs during the period. This disclosure informs investors that the fair value of investments in equities has been derived using level 1 inputs (quoted prices for identical assets in active markets). This measurement required no judgement, eliminating the risk of bias, and can be verified by knowledgeable third parties. 20 KAPLAN PUBLISHING  Chapter 1 In contrast, the disclosure informs investors that the fair value of the contingent liability has been derived using level 3 inputs. This measurement therefore involved a high level of judgement, increasing the risk of management bias. There is also a risk that the amount the entity eventually pays will differ materially from the year-end carrying amount. For this reason, the disclosure provides additional information about how management have estimated the fair value of the liability, so that the investors can assess the adequacy of the methodology used and reach a conclusion as to whether the level of measurement uncertainty is acceptable to them. Due to the level of risk, some investors may decide to sell their shares in an entity if its fair value measurements are overly reliant on level 3 inputs. Test your understanding 6 – Conceptual Framework The Conceptual Framework says that the purpose of financial reporting is to provide useful financial information to users of the financial statements. Required: Discuss how the application of IFRS 13 enhances the usefulness of financial information. Your answer should refer to the qualitative characteristics of useful financial information. KAPLAN PUBLISHING 21 Frameworks 4 Chapter summary 22 KAPLAN PUBLISHING  Chapter 1 Test your understanding answers Test your understanding 1 – Bottle The brand is an economic resource controlled by Bottle. It has the potential to bring economic benefits because of the exposure that Bottle-branded books receive. Despite meeting the definition of an element, the brand is not recognised in the financial statements. However, the Conceptual Framework states that elements should only be recognised if this provides relevant information, or a faithful representation of the asset or liability. If there is a high degree of measurement uncertainty then recognition may not provide a faithful representation. The cost of an internally generated brand cannot be reliably measured. This is because the costs of setting up and developing the brand cannot be separated from the operating costs of the business. The fair value of a brand is also very difficult to determine because brands are unique. Thus, it would seem that the accounting treatment of the brand, per IAS 38 Intangible Assets, is consistent with the Conceptual Framework. Test your understanding 2 – Cryptocurrencies One of the purposes of the Conceptual Framework is to assist preparers of financial statements when no IFRS Standard applies to a particular transaction. The definition of an asset in the Conceptual Framework is an economic resource controlled by an entity from a past event. Cryptocurrency meets this definition because it can be traded or used to buy goods and therefore have the potential of producing economic benefits. Items should be recognised in the financial statements if they meet the definition of an element and if recognition provides relevant information and a faithful representation of the underlying item. If cryptocurrency is traded then information about such investments will help users when assessing an entity’s future cash flows. As such, recognition is appropriate. When measuring e