Conceptual Framework for Financial Reporting II PDF

Conceptual framework for financial reporting II DR. INI E. UDOFIA  At the end of the lesson, students should be able to explain: A Explain the meaning and purpose of conceptual framework. LEARNING B Explain the objectives, qualitativ...

Conceptual framework for financial reporting II DR. INI E. UDOFIA  At the end of the lesson, students should be able to explain: A Explain the meaning and purpose of conceptual framework. LEARNING B Explain the objectives, qualitative characteristics OUTCOMES and limitations of financial statements. C Discuss the underlying assumptions in preparing financial statements. D Identify users of financial statements and their information needs. E Identify and discuss the components of financial statements. F Explain the concept of capital maintenance G Differentiate between principle-based and rule- based financial reporting frameworks. H Discuss financial statements in relation to reporting entities under the conceptual framework.  Reporting financial information that Cost is relevant and faithfully represents what it purports to represent helps constraint users to make decisions with more on useful confidence. This results in more information efficient functioning of capital markets and a lower cost of capital for the economy as a whole. An individual investor, lender or other creditor also receives benefits by making more informed decisions. However, it is not possible for general purpose financial reports to provide all the information that every user finds relevant 3  The IASB conceptual framework for financial reporting is made up of the following sections: Chapters in Chapter 1 – The objective of general- the IASB purpose financial reporting. conceptual Chapter 2 – Qualitative characteristics of useful financial information. framework Chapter 3 – Financial statements and the reporting entity. Chapter 4 – The elements of financial statements. Chapter 5 – Recognition and derecognition. Chapter 6 –Measurement. Chapter 7 – Presentation and disclosure. Chapter 8 – Concepts of capital and capital maintenance. 4  The benefits obtained from financial information should exceed Cost vs. the cost of obtaining and providing benefit of it. Information should not be provided if the cost is not worth the financial benefit. information Since it is difficult to measure the benefits of financial information, the setters of accounting standards must use their judgement in deciding whether certain items of information should be provided in the financial statements (and if so, in how much detail). 5  CHAPTER 4: The IASB Framework discusses THE the five elements of financial ELEMENTS statements: OF FINANCIAL for reporting financial position: STATEMENTS assets, liabilities and equity; and for reporting financial performance: income and expenses. 6  An asset is a present economic resource controlled by the entity as a result of past events. Assets An economic resource is a right that has the potential to produce economic benefits. Rights Rights can take many forms including the right to receive cash, exchange resources on favourable terms, rights over physical objects and rights to use intellectual property. Many rights are established by contract, legislation or similar means. 7  However, rights might be obtained in other ways (e.g., developing know-how that is not Rights in the public domain). In order to be an asset, rights must both have the potential to produce economic benefits for the entity beyond those available to all other parties and be controlled by the entity. Therefore, not all rights are assets (e.g., right to use public infrastructure is not an asset). 8  An economic resource is a right that Potential has the potential to produce to produce economic benefits. economic A right can be an asset, even if the benefits probability that it will produce economic benefits is low. However, low probability might affect decisions about what information to provide about the asset and how to provide that information, including decisions about whether the asset is recognised and how it is measured. 9  Control links an economic resource to an entity Control Control is the ability to obtain economic benefits from the asset, and to restrict the ability of others to obtain the same benefits from the same item. 10  A liability is a present obligation of the entity to transfer an economic resource as a result of past events. For a liability to exist, three criteria must all be satisfied: Liabilities Obligation An obligation is a duty or responsibility that an entity has no practical ability to avoid. An obligation is always owed to another party (or parties) but it is not necessary to know the identity of the party (or parties) to whom the obligation is owed. Obligations might be established by contract or other action of law or they might be constructive. A constructive obligation arises from an entity’s customary practices, published policies or specific statements when the entity has no practical ability to act in a manner inconsistent with those practices, policies or statements. 11  An obligation must have the potential to require the entity to Transfer of transfer an economic resource to economic another party (or parties). resource An obligation can meet the definition of a liability even if the probability of a transfer of an economic resource is low. However, low probability might affect decisions about what information to provide about the liability and how to provide that information, including decisions about whether the liability is recognised and how it is measured. 12  A liability is an obligation that already Present exists. An obligation may be legally obligation enforceable as a result of a binding contract or a statutory requirement, as a result such as a legal obligation to pay a of past supplier for goods purchased. events Obligations may also arise from normal business practice, or a desire to maintain good customer relations or the desire to act in a fair way. For example, an entity might undertake to rectify faulty goods for customers, even if these are now outside their warranty period. This undertaking creates an obligation, even though it is not legally enforceable by the customers of the entity. 13  A liability arises out of a past transaction or event. Past A present obligation exists as a transactions result of past events only if: or events the entity has already obtained economic benefits or taken an action; and as a consequence, the entity will or may have to transfer an economic resource that it would not otherwise have had to transfer. For example, a trade payable arises out of the past purchase of goods or services, and an obligation to repay a bank loan arises out of past borrowing. 14  Equity : Equity is the residual interest in an entity after the value of all its liabilities has been deducted from the Other value of all its assets. definitions Income: Income is increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims. The concept of income includes both revenue and gains. Revenue: is income arising in the course of the ordinary activities of the entity. It includes sales revenue, fee income, royalties income, income and income from investments (interest and dividends). Revenue is recognised in the statement of profit or loss. 15  Gains represent other items that meet the definition of income. Gains may be recognised in the statements of profit or loss or in the statement of other Other comprehensive income. For example: definitions Gains on the disposal of non-current assets. These are recognised in the statement of profit or loss. Unrealised gains which occur whenever an asset is revalued upwards but is not disposed of. Unrealised gains might be recognised in the statement of profit or loss (e.g. revaluation gains on property accounted for under IAS 16) or in the statement of other comprehensive income (e.g. revaluation gains on property accounted for under the IAS 40 fair value model). 16  Expenses Expenses are decreases in assets, or increases in liabilities, that result in Other decreases in equity, other than those definitions relating to distributions to holders of equity claims. Expenses include: Expenses arising in the normal course of activities, such as the cost of sales and other operating costs, including depreciation of non- current assets. Expenses result in the outflow of assets (such as cash or finished goods inventory) or the depletion of assets (for example, the depreciation of non-current assets). 17  Losses include for example, the Elements of loss on disposal of a non-current financial asset, and losses arising from statements: damage due to fire or flooding. Other Losses are usually reported as definitions net of related income. Financial performance is measured by profit or loss and gains or losses recognised in other comprehensive income. Profit is measured as income less expenses. 18  Recognition is the process of capturing for inclusion in the statement of financial position or the statement(s) of financial performance an item Chapter 5: that meets the definition of one of the elements RECOGNITION of financial statements. AND Recognition involves depicting the item in words DERECOGNITION and by a monetary amount. The amount at which an asset, a liability or equity is recognised in the statement of financial position is referred to as its carrying amount. Recognition links the elements as the recognition of one item (or a change in its carrying amount) requires the recognition or derecognition of another item. For example, revenue is recognised at the same time as the corresponding receivable. 19  for an asset, derecognition recognition normally occurs when the entity and loses control of all or part of the derecognition recognised asset; and criteria for a liability, derecognition normally occurs when the entity no longer has a present obligation for all or part of the recognised liability. 20  Derecognition is the removal of all or part of a recognised asset or liability from an entity’s statement Derecognition of financial position. This normally occurs when that item no longer meets the definition of an asset or of a liability: for an asset, derecognition normally occurs when the entity loses control of all or part of the recognised asset; and for a liability, derecognition normally occurs when the entity no longer has a present obligation for all or part of the recognised liability. 21  There are three bases of accounting which go to the heart of how transactions are recognised and Chapter 7: measured: Accruals basis; Presentation cash basis; and and break up basis disclosures The accruals basis is by far the most important and popularly applied of these three in practice. Example: Accruals vs. cash basis A company prepares its financial statements to the 31 December each year. It sells goods for ₦50,000 to a customer on 6 December Year 2 but does not receive a cash payment from the customer until 15 January Year 3. How will this transaction be treated using: i. Accrual basis ii. cash basis 22  Accruals basis The sale is recognised as income in the year to 31 December Year 2, even though the cash is not received until after the end of this financial year. Cash basis Basis of The sale is recognized as income in Year 3, even Accounting though sale was made in year 2. ₦50,000 is recognised as revenue under each basis but in different periods. Example: Break-up basis A company prepares its financial statements to the 31 December each year. The company is in severe financial difficulty and is not expected to survive. It has a building in its accounts carried at ₦1,500,000. Real estate professionals have advised that this building could be sold for only ₦1,200,000 in the current market conditions. Break-up basis The building should be remeasured at₦1,200,000 in the financial statements. 23  Classification is the sorting on the basis of shared characteristics for presentation and disclosure purposes. Classification Such characteristics include - but not limited to - the nature of the item, its role (or function) within the business activities conducted by the entity, and how it is measured. Classifying dissimilar assets, liabilities, equity, income or expenses together can obscure relevant information, reduce understandability and comparability, and may not provide a faithful representation of what it purports to represent. Classification is applied if doing so would enhance the usefulness of the resulting financial information 24  Income and expenses are classified and included either: (a) in the statement of profit or loss; or (b) outside the statement of profit or loss, Classification in other comprehensive income. The statement of profit or loss is the primary source of information about an entity’s financial performance for the reporting period. Understanding an entity’s financial performance for the period requires an analysis of all recognised income and expenses - including income and expenses included in other comprehensive income - as well as an analysis of other information included in the financial statements. 25  The Conceptual Framework allows two principal measurement bases that are used for the elements of financial statements. Chapter 6: These include: Historical cost and current MEASUREMENT value Historical cost. Historical cost provides monetary information about assets, liabilities and related income and expenses. The historical cost of an asset when it is acquired or created is the value of the costs incurred in acquiring or creating the asset, comprising the consideration paid to acquire or create the asset plus transaction costs. The historical cost of a liability when it is incurred or taken on is the value of the consideration received to incur or take on the liability minus transaction costs. 26  Current value of the asset or liability is used as a deemed cost on initial recognition when an asset is acquired or created, or a liability is incurred or taken on, as a result of an event that is not a transaction on market terms and that deemed Current cost is then used as a starting point for value subsequent measurement at historical cost. This is because it may not be possible to identify a cost, or the cost may not provide relevant information about the asset or liability Current value measures provide monetary information about assets, liabilities and related income and expenses, using information updated to reflect conditions at the measurement date. Because of the updating, current values of assets and liabilities reflect changes, since the previous measurement date, in estimates of cash flows and other factors reflected in those current values. 27  (a) fair value; (b) value in use for assets and fulfilment value for liabilities; and Current value (c) current cost. Fair value is the price that would be received to measurement sell an asset, or paid to transfer a liability, in an orderly transaction between market participants bases at the measurement date. Fair value reflects the perspective of market participants. The asset or liability is measured using the same assumptions that market participants would use when pricing the asset or liability, if those market participants act in their economic best interest. Fair value is easy to understand and less complicated to apply than value to the business/current value. Arguably, it is also more reliable to the business, because market value is more easily verified than (for example) economic value. 28  In some cases, fair value can be determined directly by observing prices in an active market. In other cases, it is determined indirectly using measurement techniques, for example, cash flow-based measurement techniques, reflecting all the following factors: Fair value (a) estimates of future cash flows; (b) possible variations in the estimated amount or timing of future cash flows for the asset or liability being measured, caused by the uncertainty inherent in the cash flows; (c) the time value of money; (d) the price for bearing the uncertainty inherent in the cash flows (a risk premium or risk discount). The price for bearing that uncertainty depends on the extent of that uncertainty. It also reflects the fact that investors would generally pay less for an asset (and generally require more for taking on a liability) that has uncertain cash flows than for an asset (or liability) whose cash flows are certain; and (e) other factors, for example, liquidity, if market participants would take those factors into account in the circumstances. 29  However, it has some serious disadvantages: ‰ There may not be an active market for some kinds Problems of asset. Where there is no active market, estimates have to be used and these may not be reliable. with the ‰ It anticipates sales and profits which may never happen (the entity may have no plans to sell the use of fair asset). value ‰ Market values can move up and down quite rapidly. This may distort trends in the financial statements and make it difficult for users to assess an entity’s performance over time. A notable example of this problem occurred during 2007 and 2008 with Many banks, particularly in the US and Europe, announced huge losses, due largely to the requirement to write down their investments in these financial instruments to fair value, even though fair value was difficult to assess. Despite these problems, it looks increasingly likely that the IASB will require greater use of fair value in future. 30  Value in use is the present value of the cash flows, or other economic benefits, that an entity Value in expects to derive from the use of an asset and from its ultimate disposal. Fulfilment value is the use and present value of the cash, or other economic resources, that an entity expects to be obliged to fulfilment transfer as it fulfils a liability. Those amounts of value cash or other economic resources include not only the amounts to be transferred to the liability counterparty, but also the amounts that the entity expects to be obliged to transfer to other parties, to enable it to fulfil the liability. Because value in use and fulfilment value are based on future cash flows, they do not include transaction costs incurred in acquiring an asset or taking on a liability. However, value in use and fulfilment value include the present value of any transaction costs an entity expects to incur on the ultimate disposal of the asset or on fulfilling the liability. 31  The current cost of an asset is the cost of an equivalent asset at the measurement date, comprising the consideration that would be paid Current at the measurement date plus the transaction cost costs that would be incurred at that date. The current cost of a liability is the consideration that would be received for an equivalent liability at the measurement date minus the transaction costs that would be incurred at that date. Current cost, like historical cost, is an entry value: it reflects prices in the market in which the entity would acquire the asset or would incur the liability. Unlike historical cost, current cost reflects conditions at the measurement date. 32  In some cases, current cost cannot be determined directly by observing prices in an active market and must be determined Current indirectly by other means cost vs. Historical cost is the most commonly used historical measurement basis. However, the other bases of measurement are often used to cost modify historical cost. For example, inventories are measured at the lower of cost and net realisable value. Deferred income is measured at present value. Some non-current assets may be valued at current value. The Framework does not favour one measurement base over the others, however fair value may be favoured over historical costs for financial instrument and investment property 33  The Conceptual Framework states that there are two concepts of capital: Chapter 9: Different systems of accounts used different capital maintenance concepts. The choice of Capital capital maintenance has a profound effect on the maintenance measurement of profit. Financial capital maintenance and Physical concepts capital maintenance With the financial concept of capital maintenance, a profit is not earned during a period unless the financial value of equity at the end of the period exceeds the financial value of equity at the beginning of the period (after adjusting for equity capital raised or distributed). There are two major approaches: i. money financial capital maintenance ii. real financial capital maintenance 34  Money financial capital maintenance: Under this concept, an entity makes a profit when its closing equity exceeds its opening Money vs. equity measured as the number of units of real financial currency at the start of the period. Note that this is a separate issue from asset capital valuation. Assets could be revalued during maintenance the period, but this would have no effect on the opening capital. Real financial capital maintenance: Under this concept, an entity makes a profit when its closing equity exceeds opening equity re-measured to maintain its purchasing power. This requires the opening equity to be uplifted by the general inflation rate. This is achieved by a simple double entry. 35  A physical concept of capital is that the capital of an entity is represented by its productive capacity or operating capability. Where a physical concept Physical of capital is used, the main concern of users of the financial statements is with the maintenance of capital the operating capability of the entity. maintenance With a physical concept of capital maintenance, a profit is not earned during a period unless (excluding new equity capital raised during the period and adding back any distribution of dividends to shareholders) the operating capability of the business is greater at the end of the period than at the beginning of the period. This requires the opening equity to be uplifted by the specific rates of inflation that apply to the individual components of the net assets of the company. Again, this is achieved by the same simple double entry. 36  X Ltd commenced business on January 1 with a single item of inventory costing N10,000. Example During the year, the item was sold for N14000 (cash). During the year, general inflation was 5% but the inflation specific to the item was 10%. Profit is calculated under each concept in the following ways: 37  Statement of Financial Financial Physical profit or loss (money (real terms) N terms) N N Capital Revenue 14,000 14,000 14,000 maintenance Cost of sale (10,000) (10,000) (10,000) Inflation adjustment (inflation rate applied to opening equity): 5%*N10,000 (500) 10%*N10,000 (1000) 4,000 3,500 3,000 38  Statement of financial N N N position Net assets 14,000 14,000 14,000 Capital (CASH) maintenan Equity: ce Opening equity Before 10,000 10,000 10,000 adjustment Inflation reserve 500 1,000 After 10,000 10,500 11,000 adjustment Retained profit (profit for the 4,000 3,500 3,000 year) 14,000 14,000 14,000 39  Under historical cost accounting, the profit is N4,000. If the business paid this out as a dividend it would have N10,000 left. N10,000 is the opening equity expressed as a number of units of currency. This means that the company would Commentary have maintained its equity expressed as a number of units of currency. However, inflation in the period has caused the on the purchasing power of the currency to decline. This means example that N10,000 no longer has the same purchasing power that it had a year ago. The company has not maintained its capital in real terms. To maintain its opening equity in real terms the company would have to ensure that it had the same purchasing power at the year-end as it had at the start. Inflation was 5% so the company would need N10,500 at the year-end in order to have the same purchasing power as it had at the start of the year. The company can achieve this by transferring N500 from profit and loss into an inflation reserve. Profit would then be reported as N3,500. 40  If the business paid out N3,500 as a dividend it would have N10,500 left. This is not enough to buy the same asset that it had at the start of the year. The asset has been subject to specific Commentary inflation of 10% therefore the company would need N11,000 at the year-end in order to buy on the the same asset. example This means that the company would not have the same capacity to operate as it had a year ago. To maintain its opening equity in physical terms the company would have to ensure that it had the same ability to operate at the year-end as it had at the start. In other words it would need to have N11,000. The company can achieve this by transferring N1,000 from profit and loss into an inflation reserve. Profit would then be reported as N3,000. 41  Neither the IASB Conceptual Framework nor accounting standards require the use of a specific capital maintenance concept. In practice, Comparing almost all entities use money financial capital maintenance, but both concepts can provide the two useful information. concepts Financial capital maintenance is likely to be the most relevant to investors as they are interested in maximising the return on their investment and therefore its purchasing power. Physical capital maintenance is likely to be most relevant to management and employees as they are interested in assessing an entity’s ability to maintain its operating capacity. This is particularly true for manufacturing businesses, where management may need information about the ability of the business to continue to produce the same or a greater volume of goods. 42 ANY QUESTIONS? THE END 43