Financial Accounting And Reporting PDF

FINANCIAL ACCOUNTING AND REPORTING | 9 1 THE PURPOSE OF ACCOUNTING LO 1.2 Section overview  Accounting is the process of recording, analysing and summarising transactions of an entity...

FINANCIAL ACCOUNTING AND REPORTING | 9 1 THE PURPOSE OF ACCOUNTING LO 1.2 Section overview  Accounting is the process of recording, analysing and summarising transactions of an entity MODULE 1 and communicating that information to decision makers.  A business is an entity which exists to make a profit.  There are three main types of business entity: sole traders, partnerships and limited liability companies.  Not-for-profit entities such as charities, clubs and government entities may also prepare accounts. 1.1 WHAT IS ACCOUNTING? You may have a wide understanding of what accounting and financial reporting is. Your job may be in one area or type of accounting, but you must understand the breadth of work which an accountant undertakes. In particular, you need to understand the distinction between financial accounting and management accounting. Definition Accounting is the process of recording, analysing and summarising transactions of a business and communicating that information to decision makers. Renaissance scholar Luca Pacioli wrote the first printed explanation of double-entry bookkeeping in 1494. Double-entry bookkeeping involves entering every transaction as a debit in one account and a corresponding credit in another account, and ensuring that they balance. Pacioli's description of the method was widely influential. The first English book on the subject was written in 1543 by John Gouge. The practice of double-entry bookkeeping has barely changed since then and is standard across the world, based upon the concept that every transaction has a dual effect expressed as debits equals credits. The original role of the accounting function was to record financial information and this is still its main focus. Why do businesses need to produce accounts? If a business is being run efficiently, why should it have to go through all the bother of accounting procedures in order to produce financial information? A business needs to produce information about its activities because there are various groups of people who want or need to know that information. Later in this module we will consider the different groups of users and the type of information that is of interest to the members of each group. 1.2 FINANCIAL ACCOUNTING Definition Financial accounting is a method of reporting the results and financial position of a business. It is not primarily concerned with providing information towards the more efficient running of the business. Although financial accounts are of interest to management, their principal function is to satisfy the information needs of persons not involved in running the business, in particular shareholders. Financial accounts provide historical information.  10 | THE FINANCIAL REPORTING ENVIRONMENT 1.3 MANAGEMENT ACCOUNTING The information needs of management go far beyond those of other account users. Managers have the responsibility of planning and controlling the resources of the business and for making decisions about the direction of the business both in the longer term and on a day to day basis. Therefore they need much more detailed information. They also need to plan for the future, for example, budgets, which predict future revenue and expenditure. Definition Management accounting, sometimes known as cost accounting, is a management information system which analyses data to provide information as a basis for managerial action. The concern of a management accountant is to present accounting information in the form most helpful to management. 1.4 WHAT IS A BUSINESS? Definition A business is an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs or other economic benefits directly to investors or other owners, members or participants. Businesses of whatever size or nature exist to make a profit. There are a number of different ways of looking at a business. Some ideas are listed below.  A business is a commercial or industrial concern which exists to deal in the manufacture, re-sale or supply of goods and services.  A business is an organisation that uses economic resources to create goods or services which customers will buy.  A business is an organisation providing jobs for people.  A business invests money in resources for example, buildings, machinery, employees, in order to make even more money for its owners. This last definition introduces the important idea of profit. Businesses vary from very small businesses for example, the local shopkeeper or plumber, to very large ones for example, IKEA, Nestlé, Unilever. However all of them want to earn profits. Definition Profit is the excess of revenue (income) over expenses. When expenses exceed revenue, the business is running at a loss. One of the jobs of an accountant is to measure revenue and expenditure, and so profit. 1.5 TYPES OF BUSINESS ENTITY There are three main types of business entity:  Sole traders;  Partnerships; and  Limited liability companies. Sole traders are people who work for themselves. Examples may include the local shopkeeper, a plumber and a hairdresser. The term sole trader refers to the ownership of the business – sole traders can have employees.  FINANCIAL ACCOUNTING AND REPORTING | 11 Partnerships occur when two or more people decide to run a business together. Examples may include an accountancy practice, a medical practice and a legal practice. Limited liability companies are incorporated to take advantage of 'limited liability' for their owners (shareholders). This means that, unlike sole traders and partners, who are personally responsible for the amounts owed by their business, the shareholders of a limited liability company are only responsible for the amount unpaid on their shares. This means that if the shareholders have MODULE 1 purchased shares costing $100 but have only paid $40 to date, they would have to contribute the remaining $60 towards paying the company's debts. Generally, in law sole traders and partnerships are not separate entities from their owners. This is true in many jurisdictions, for example, Australia, the UK, India, New Zealand, China, Japan and Germany. In the US, however, partnerships do have separate legal personality but the partners are wholly liable for debts of the partnership. In all cases, however, a limited liability company is legally a separate entity from its owners and it can issue contracts in the company's name. For accounting purposes, all three entities are treated as separate from their owners. This is called the business entity concept. The methods of accounting used in all three types of business entities will be very similar, although will tend to become more complex the larger the entity. 1.5.1 NOT-FOR-PROFIT ENTITIES It is not only businesses that need to prepare financial statements. Charities and clubs, for example, may need to prepare financial statements every year. Financial statements also need to be prepared for government organisations (public sector organisations such as hospitals and local councils). 2 NATURE, PRINCIPLES AND SCOPE OF FINANCIAL REPORTING LO 1.1 Section overview  Financial reporting is the process of classifying, recording and presenting financial data in accordance with generally established concepts and principles. 2.1 WHAT IS FINANCIAL REPORTING? Financial data is the name given to the record of actual transactions carried out by a business for example, sales of goods, purchases of goods, payment of expenses. These transactions are analysed according to type, recorded in ledger accounts and summarised in the financial statements. Financial reporting is the process of reporting the results and financial position of an entity. Although financial accounts are of interest to management, their principal function is to provide historical information in order to satisfy the information needs of external users such as shareholders. Financial accounting is not primarily concerned with providing information towards the more efficient running of the business – this is the function of a separate branch of accounting, known as 'management accounting'. 2.2 GENERAL PURPOSE FINANCIAL REPORTING The Conceptual Framework (and company law in some countries) prescribe that a company should produce financial information about the reporting entity's assets, liabilities, equity, income and expenses that is useful to users of financial statements in assessing the prospects for future net cash inflows to the reporting entity and in assessing management's stewardship of the entity's economic resources (Conceptual Framework para.3.2). Accounts must normally be presented at least annually, and there are usually detailed regulations on what they must contain and the form they must take. For example, in Australia, the form and content of company financial statements is regulated by the Corporations Act 2001 and by Australian  12 | THE FINANCIAL REPORTING ENVIRONMENT Accounting Standards. The Australian Accounting Standards Board adopted the IFRSs for Australian entities required to report under the Corporations Act 2001 (Cwlth) (Corporations Act) for annual reporting periods beginning on or after 1 January 2005. Large listed companies (sometimes known as public companies) are required to publish their annual financial statements. A listed company is a company whose shares or debt instruments are publicly traded on a stock exchange. Published financial statements may be printed or made available on the company's website. In some countries, for example, the UK, all limited companies must 'publish' their annual accounts by filing them with the Registrar of Companies. They are then available to members of the public. These 'published' annual financial statements are general purpose financial statements or general purpose financial reports. In this module, the terms 'financial reports' and 'financial reporting' refer to general purpose financial reports and general purpose financial reporting unless otherwise noted. General purpose financial statements such as the statement of profit or loss and other comprehensive income, statement of financial position, statement of changes in equity, and the statement of cash flows and the notes make up the body of general purpose financial reports that are prepared for external users. They contain information which may be useful to a wide range of users external to the company. They are distinct from non-general purpose financial statements, commonly known as special purpose financial reports which are prepared for a particular group of users and for a particular purpose. Financial report prepared for the use of tax computations, bank reporting and for fulfilment of members reporting responsibilities are some examples of special purpose financial reports. Some users of financial statements are able to obtain additional information. For example, owners or lenders may be able to request forecasts and budgets and members of the public have access to information in the financial press or on the internet. However, generally, most external users have to rely on the annual financial statements as their major source of financial information. Financial statements do not include directors' reports, statements by the chairman, management commentaries or environmental and social reports, although these may be included in the published annual report of a large listed company (see Module 2). 2.3 LIMITATIONS OF FINANCIAL REPORTING General purpose financial statements cannot possibly provide all the information that external users might need about a company or business. Users may also need to consider information from other sources, such as general economic conditions, the political situation and conditions in the industry in which the business operates. There are other inherent limitations of the financial accounting and reporting process.  Financial statements are based on estimates and judgments. For example, management must estimate the useful lives of assets and the likelihood that amounts receivable will actually be received. Preparing financial statements and reports involves classifying and aggregating (adding together) information about transactions and other events. It also involves allocating the effects of continuous business transactions over separate accounting periods.  Financial statements are based on historical information. They do not reflect future events or transactions that may affect the business and the way that it operates. Users of the financial statements normally need to predict how well a business will perform in future and to understand the factors which may affect its future performance.  Financial statements largely record only the financial effects of transactions and events. For example, intangible assets such as the technical expertise of the workforce may have a very significant effect on a company's performance. However, these 'assets' are not recognised because they cannot be reliably valued at a monetary amount. Financial statements do not include non-financial information such as discussion of the risks and uncertainties that a business faces, or a description of its effect on the natural environment.  FINANCIAL ACCOUNTING AND REPORTING | 13 Question 1: Financial reporting Financial reporting means the financial statements produced only by a large listed company. Is this statement correct? A Yes B No MODULE 1 (The answer is at the end of the module.) 3 USERS' AND SHAREHOLDERS' NEEDS LO 1.4 Section overview  There are various groups of people who need information about the activities of a business. 3.1 THE NEED FOR FINANCIAL STATEMENTS The purpose of financial statements is to provide useful information about the financial position, performance and changes in financial position of an entity to a wide range of users. Users need this information for two reasons: 1. To make economic decisions; and 2. To assess the stewardship of management. 3.1.1 MAKING ECONOMIC DECISIONS The types of economic decisions for which financial statements are likely to be used include the following:  Decisions to buy, hold or sell equity investments;  Assessment of management stewardship and accountability;  Assessment of the entity's ability to pay employees;  Assessment of the security of amounts lent to the entity;  Determination of taxation policies;  Determination of distributable profits and dividends;  Inclusion in national income statistics; and  Regulation of the activities of entities. 3.1.2 STEWARDSHIP Stewardship is relevant where an organisation is managed by people other than its owners. For example, the owners of a listed company appoint directors to run the company on their behalf, who are then accountable for the company's resources. They must use these resources efficiently and effectively to produce profits or other benefits for the owners. Owners need to be able to assess the performance of the directors so that they can decide whether to reappoint them or remove them and how much they should be paid. 3.2 USERS OF FINANCIAL STATEMENTS AND ACCOUNTING INFORMATION A business should produce information about its activities because there are various groups of people who want or need to know that information. Large businesses are of interest to a greater variety of people and so we will consider the case of a listed company, whose shares can be purchased and sold on a stock exchange.  14 | THE FINANCIAL REPORTING ENVIRONMENT The following people are likely to be interested in financial information about a company with listed shares.  Managers of the company appointed by the company's owners to supervise the day-to-day activities of the company. They need information about the company's financial situation as it is currently and as it is expected to be in the future. This is to enable them to manage the business efficiently and to make effective decisions.  Shareholders of the company, that is, the company's owners, want to assess how well the management is performing. They want to know how profitable the company's operations are and how much profit they can afford to withdraw from the business for their own use.  Trade contacts include suppliers who provide goods to the company on credit and customers who purchase the goods or services provided by the company. Suppliers want to know about the company's ability to pay its debts; customers need to know that the company is a secure source of supply and is in no danger of having to close down.  Providers of finance to the company might include a bank which allows the company to operate an overdraft, or provides longer-term finance by granting a loan. The bank wants to ensure that the company is able to keep up interest payments, and eventually to repay the amounts advanced.  The taxation authorities want to know about business profits in order to assess the tax payable by the company, including sales taxes, for example, Goods and Services Tax or Value Added Tax.  Employees of the company should have a right to information about the company's financial situation, because their future careers and the size of their wages and salaries depend on it.  Financial analysts and advisers need information for their clients or audience. As examples, stockbrokers need information to advise investors; credit agencies want information to advise potential suppliers of goods to the company; and journalists need information for their reading public.  Government and their agencies are interested in the allocation of resources and therefore in the activities of business entities. They also require information in order to provide a basis for national statistics.  The public. Companies affect members of the public in a variety of ways. They may make a substantial contribution to a local economy by providing employment and using local suppliers. Another important factor is the effect of an entity on the environment as an example in relation to pollution. Accounting information is summarised in financial statements to satisfy the information needs of these different groups. These information needs will differ between each user group and not all will be equally satisfied. 3.3 NEEDS OF DIFFERENT USERS Managers of a business need the most information, to help them make their planning and control decisions. They clearly have 'special' access to information about the business, because they are able to demand whatever internally produced statements they require. When managers want a large amount of information about the costs and profitability of individual products, or different parts of their business, they can obtain it through a system of cost and management accounting rather than rely on the financial accounts. Shareholders, providers of finance and financial analysts and advisers need information that helps them to make decisions: whether to buy, hold or sell their investment in a business or whether to lend money to it. Unlike managers, these users are external to the business. Therefore they normally have to rely on the published financial statements to provide them with the information that they need. For this reason, in most developed countries, including Australia, published financial statements are primarily prepared to meet the information needs of existing and potential investors and lenders and their advisors.  FINANCIAL ACCOUNTING AND REPORTING | 15 Question 2: Information needs Which of the following items in the financial statements of a company would be of particular interest to a customer? A Operating profit B Retained earnings C Dividend payments MODULE 1 D Directors' remuneration (The answer is at the end of the module.) 4 THE NEED FOR A REGULATORY FRAMEWORK LOs 1.1, 1.3 Section overview  The regulatory framework ensures that general purpose financial reporting produces relevant and reliable information and therefore meets the needs of shareholders, lenders and other users.  Generally accepted accounting principles (GAAP) signifies all the rules, from whatever source, that govern accounting. GAAP includes accounting standards (IFRS and national standards), national company law, and local stock exchange requirements.  Regulation of companies and their published financial information can vary significantly in different countries throughout the world. 4.1 SUBJECT OUTLINE The regulatory framework consists of accounting rules and company law. These ensure that general purpose financial reporting provides useful information that meets the needs of shareholders, lenders and other users. The International Accounting Standards Board (IASB) develops and issues International Financial Reporting Standards (IFRS). As IFRS have no jurisdiction, and the IASB has no authority to impose accounting standards, individual countries draw up their own accounting regulations. In practice, national governments often adopt IFRS and then adapt them to operate together with local laws and regulations as necessary. 4.2 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) Generally accepted accounting principles (GAAP) signifies all the rules, from whatever source, which govern accounting. The concept is applicable globally. In individual countries GAAP is seen primarily as a combination of:  national company law;  national accounting standards; and  local stock exchange requirements. Although these sources are the basis for the GAAP of individual countries, the concept also includes sources such as:  IFRS; and  accounting requirements of other countries. In many countries, GAAP does not have any statutory or regulatory authority or definition. There are different views of GAAP in different countries. The IASB convergence program seeks to reduce these differences.  16 | THE FINANCIAL REPORTING ENVIRONMENT GAAP can be based on legislation and accounting standards that are either:  prescriptive/rules-based; or  principles-based. The US operates a prescriptive system, where standards are very detailed, attempting to cover all eventualities. Accounts which do not comply in all details are presumed to be misleading. This has the advantage of clear requirements which can be generally understood and it removes any element of judgment. In general, international financial reporting standards (IFRS) are principles-based. They do not specify all the details but seek to obtain adherence to the 'spirit' of the regulations. This leaves room for some element of professional judgment. It also makes it harder for entities to avoid applying a standard as the terms of reference are broader. (We will be discussing the differences between rules-based standards and principles-based standards in more detail later in this module.) 4.2.1 INDIVIDUAL JUDGMENT Financial statements are prepared on the basis of a number of fundamental accounting assumptions and conventions. Many figures in financial statements are derived from the application of judgment in putting these assumptions into practice. It is clear that different people exercising their judgment on the same facts can arrive at very different conclusions. Question 3: Judgment An accountancy training firm has an excellent reputation amongst students and employers. How would you value this? The firm may have relatively little in the form of tangible assets that you can touch, perhaps a building, desks and chairs. If you simply drew up a statement of financial position showing the cost of the assets owned, then the business would not seem to be worth much, yet its income earning potential might be high. This is true of many service organisations where the people are among the most valuable assets. Here judgment must be used in order to reach a valuation for the business, although one person's judgment may lead to a very different valuation from another person's. Required Can you think of any other areas where judgment would have to be used in preparing financial statements? (The answer is at the end of the module.) 4.3 ADVANTAGES AND DISADVANTAGES OF REGULATION The key benefit of accounting regulation is that it requires organisations to prepare financial statements on a consistent basis. This is useful for the users of financial statements that were identified earlier in this module. For example, an investor wishing to purchase shares in a company is able to compare that company's performance with another, as their financial statements should have been prepared on the same basis. Other advantages of regulation include the following:  The existence of accounting rules reduces variations in the way financial statements are prepared. Without regulation it would be possible for preparers to adopt whatever accounting treatments they choose and to vary these from year to year in order to present the company's profit figure and net assets in as favourable a light as possible. In addition, transactions and businesses have become increasingly complex. There are many legitimate ways to present, measure and disclose items such as complex financial instruments, but the accounting treatment of these items needs to be comparable between different entities and over time.  FINANCIAL ACCOUNTING AND REPORTING | 17  Regulation means there will be rules as to what should be disclosed which improves the quality of information produced. For example, IAS 1 Presentation of Financial Statements requires companies to disclose the accounting policies that they have followed, so that users can understand the judgments that preparers have made in arriving at the amounts in the financial statements. Financial statements must also include supporting notes which analyse and explain the main line items in the financial statements. Specific information that must be disclosed is set out in MODULE 1 accounting standards and (in some cases) companies legislation.  The existence of regulation is likely to ensure that companies disclose more information about their business activities and financial results than they may have done in the absence of such regulation. There is an argument that companies resist disclosing information unless they are required to do so. There are costs associated with providing financial information. Without regulation, management is likely to be unwilling to deliver 'bad news' to investors, or to provide information that could be used by competitors.  Regulation of companies listed on stock exchanges means there are strict requirements in terms of reporting and disclosure and this is likely to protect investors. In many countries, such as Australia, the US and the UK, systems of accounting regulation were originally developed as a response to high-profile company failures and frauds in which many investors lost their savings.  A strong system of regulation will increase public confidence in the published financial statements of companies. This is particularly important since there have recently been a number of high profile corporate failures contributed to by inappropriate accounting.  Some users of financial statements (for example, major corporate investors and lenders) have the power to demand the information that they need. Other users (for example, small investors and individual members of the public) have not. Regulation protects those less powerful individuals and organisations and can therefore be seen as a social good. Disadvantages of regulation include the following:  Strict regulation could mean a lack of flexibility for some businesses. Sometimes companies have differing business environments. These companies may have to adopt accounting treatments that do not properly reflect their financial performance and position and actually lessen the quality of the information that they provide. In this situation, it may be impossible for users to make meaningful comparisons between companies.  Companies may incur high costs in complying with the regulatory rules. The cost of providing the information required may outweigh the benefits of that information. This is particularly relevant where small companies have to comply with either US regulations or the full set of International Accounting Standards (known as 'full IFRS'). Both the US and 'full IFRS' systems were designed primarily to meet the accounting needs of multinational organisations and to protect large institutional investors in those organisations. They therefore include standards on topics such as financial instruments, earnings per share, operating segment disclosure and share-based payment transactions, which are, in most cases, not relevant to smaller entities. The IASB has now developed a special standard for small and medium entities (the IFRS for SMEs) as an alternative to 'full IFRS'. This standard omits certain topics and simplifies others in order to lessen the regulatory burden on smaller entities.  Detailed rules and regulations may mean that companies spend a great deal of time 'box-ticking' without considering the spirit of the regulation they are complying with. Information is provided because it is required, even though it is of little value. The problem can be particularly acute where preparers are required to make specific narrative disclosures, for example, about corporate governance or future prospects for the business. Users frequently complain about 'boiler plate' disclosures: general statements that could apply to any company and tell the reader nothing.  Regulation leads to financial statements that contain too much information and this can obscure the overall picture that they present. The length and volume of company annual reports is steadily growing as the result of new accounting requirements. Many commentators believe that published financial statements have become too complex for anybody other than a financial reporting expert to understand.  18 | THE FINANCIAL REPORTING ENVIRONMENT Question 4: Creative accounting Creative accounting is the name given to accounting treatments which comply with all applicable accounting regulations but which have been deliberately manipulated to give a biased impression of a company's performance or financial position. From the 1990s onwards, new or improved accounting standards were developed to prevent most of these practices. Required Briefly describe two possible methods of 'creative accounting'. (The answer is at the end of the module.) 4.4 VARIATIONS IN REGULATORY REGIMES Regulation of companies and their published financial information can vary significantly in different countries throughout the world. There are many reasons for these differences. In some cases it is due to differences in company structures, local culture and ownership patterns of companies. 4.4.1 COMPANY STRUCTURE AND OWNERSHIP A country where the majority of companies are family owned with few, if any, external shareholders outside the family will need far less regulation than a country which is dominated by large multinational corporations with large numbers of shareholders, who have no connection to the business. Much of the regulation in the latter case would be to ensure that companies are acting in the best interests of shareholders. In many family companies, the shareholders and directors are the same family members, so they will already be acting in the best interests of the shareholders and will be concerned about the long-term future of the business. 4.4.2 LEVEL OF DEVELOPMENT The level of development of a nation also has an impact on its level of regulation. Developing countries are further behind in the process of setting standards and establishing regulatory regimes than industrialised nations. East Timor, a tiny nation in both territory and population, was officially accepted into the United Nations as a sovereign state in 2002 after a long-running battle for independence from Indonesia. A poor nation, it is establishing systems for long-term political and economic stability but is still struggling with the problems facing many developing nations. It is party to international conventions and standards (including IFRS), but lags behind in implementation. Cambodia is another example of a Southeast Asian developing nation where conflict and resulting economic instability means it is still 'catching up' with more industrialised nations in terms of regulation adoption and implementation. Fiji, one of the largest and economically strongest Pacific island nations, was suspended from both the Pacific Island Forum and the Commonwealth of Nations during 2009, with both suspensions currently remaining in force. Fiji's political upheaval means standard-setting and regulation is of low importance. 4.4.3 DIFFERENT PURPOSES OF FINANCIAL REPORTING In some countries the purpose of preparing financial statements is solely for tax assessment, and therefore the accounting rules are often the same as the tax rules. In other countries, financial statements exist to provide information for investor decision-making. This will have an impact on the type of regulatory system in place. 4.4.4 DIFFERENT USER GROUPS Countries have different ideas about who the relevant user groups are and their respective importance. User groups may include financiers, management, investors, creditors, customers, employees, the government and the general public. In some countries investor and creditor groups are given prominence, while in others employees enjoy a higher profile.  FINANCIAL ACCOUNTING AND REPORTING | 19 5 THE IFRS FOUNDATION AND THE IASB LOs 1.1, 1.4, Section overview 1.5  The International regulatory framework consists of the following: MODULE 1 – The International Financial Reporting Standards Foundation (IFRS Foundation); – The International Accounting Standards Board (IASB); – The International Financial Reporting Standards Advisory Council; and – The International Financial Reporting Standards Interpretations Committee.  IFRS are developed through a formal system of due process and broad international consultation involving accountants, financial analysts and other users and regulatory bodies from around the world. 5.1 SUBJECT OUTLINE The IFRS Foundation is an independent, not-for-profit private sector organisation working in the public interest. It was founded in March 2001 as the International Accounting Standards Committee (IASC) Foundation and is the parent entity of the IASB. The IFRS Foundation publishes and promotes IFRS. Its mission statement is 'to develop IFRS Standards that bring transparency, accountability and efficiency to financial markets around the world'. The governance and oversight of the IFRS Foundation and its standard-setting bodies rests with the Trustees. They are also responsible for promoting IFRS and securing the organisation's funding. The Trustees are appointed for a renewable term of three years and must have an understanding of the issues relevant to the setting and development of IFRS but are not involved in a technical capacity. Six of the Trustees must be selected from the Asia/Oceania region, six from Europe, six from North America, one from Africa, one from South America and two from the rest of the world. A Monitoring Board (established in 2009) provides a formal link between the Trustees and public capital market authorities. The Monitoring Board participates in the process for appointing Trustees and approves their appointment. It also advises the Trustees, who are required to report to it annually, and review their work. The Monitoring Board has six members drawn from the European Commission (EC), the International Organization of Securities Commissions (IOSCO), the US Securities and Exchange Commission (SEC) and other regulatory bodies. The International Accounting Standards Board is the standard-setting body and is an independent, privately-funded accounting standard setter based in London. It is a part of the International regulatory framework, reporting to the IFRS Foundation. From April 2001 the IASB assumed accounting standard setting responsibilities from its predecessor body, the International Accounting Standards Committee (IASC). The IASB has an important role to play in the regulation of financial information as it is responsible for issuing IFRS, which are then adopted for use in many different jurisdictions. Since 2001, almost 120 countries have required or permitted the use of IFRS in preparing financial information which makes the IASB the most important accounting body worldwide. Most of the remaining major economies, other than the US, have timelines in place for the move from national accounting standards to convergence with IFRS in the near future. 5.2 THE COMPOSITION OF THE IASB The IASB is an independent group of experts with recent relevant practical experience. Its members are selected so that there is a mix of auditors, preparers, users and academics. The 12 members of the IASB come from many different countries and have a diverse range of backgrounds. There are currently three members from the Asia/Oceania region; three members from Europe; two members from North America; one member from Africa; one member from South America; and two members appointed from any area, subject to maintaining overall geographical balance.  20 | THE FINANCIAL REPORTING ENVIRONMENT The IASB aims to be collaborative in its development of standards by engaging with the worldwide standard setting community as well as investors, regulators, business leaders and the global accountancy profession. 5.3 OBJECTIVES OF THE IFRS FOUNDATION AND THE IASB The formal objectives of the IFRS Foundation and IASB are as follows:  To develop, in the public interest, a single set of high quality, understandable, enforceable and globally accepted financial reporting standards based upon clearly articulated principles. These standards should require high quality, transparent and comparable information in financial statements and other financial reporting to help investors, other participants in the world's capital markets and other users of financial information to make economic decisions.  To promote the use and rigorous application of those standards.  To take account of the needs of a range of sizes and types of entities in diverse economic settings.  To promote and facilitate adoption of International Financial Reporting Standards (IFRS), being the standards and interpretations issued through the IASB, through the convergence of national accounting standards and IFRSs. 5.4 STRUCTURE OF THE IFRS FOUNDATION The structure of the IFRS Foundation has the following main features:  The IFRS Foundation oversees two main areas – the standard-setting process and the IFRS Advisory Council (previously known as the Standards Advisory Council).  The standard-setting process consists of two bodies, the IASB (as discussed above) and the IFRS Interpretations Committee. The IASB has the sole responsibility for setting international financial reporting standards.  The IFRS Interpretations Committee (previously known as the International Financial Reporting Interpretations Committee or IFRIC) comprises 14 voting members drawn from a variety of countries and professional backgrounds. The IFRS Interpretations Committee provides timely guidance on the application and interpretation of IFRS. It deals with newly identified financial reporting issues not specifically addressed in IFRS, or issues where unsatisfactory or conflicting interpretations have developed, or seem likely to develop.  The IFRS Advisory Council (previously the Standards Advisory Council) is the formal advisory body to the IASB and Trustees of the IFRS Foundation. It is comprised of a wide range of representatives from user groups, preparers, financial analysts, academics, auditors, regulators, professional accounting bodies and investor groups that are affected by and interested in the IASB's work. Members of the Advisory Council are appointed by the Trustees. It meets three times a year to advise the IASB on a range of issues including the IASB's agenda and work program.  FINANCIAL ACCOUNTING AND REPORTING | 21 The structure of the IFRS Foundation can be illustrated as follows: Monitoring Board of public capital market authorities appoints, monitors reports to MODULE 1 IFRS Foundation Trustees (Governance) oversee, review effectiveness, appoint inform informs appoint and finance IFRS Advisory Council Standard setting International Accounting Standards Board (IASB) (IFRS/IFRS for SMEs) provides strategic advice IFRS Interpretations Committee IFRS Foundation support operations Education Initiative, IFRS Taxonomy (XBRL), Content Services 5.5 THE STANDARD SETTING PROCESS IFRS are developed through a formal system of due process and broad international consultation involving accountants, financial analysts and other users and regulatory bodies from around the world. The process of developing an accounting standard has six stages as follows: Step 1 Setting the agenda. The IASB evaluates the merits of adding a potential item to its agenda mainly by reference to the needs of investors. The IASB considers:  the relevance to users of the information and the reliability of information that could be provided;  whether existing guidance is available;  the possibility of increasing convergence;  the quality of the standard to be developed; and  resource constraints. The IFRS Advisory Council and the IFRS Interpretations Committee, other standard-setters and other interested parties may have made comments on accounting issues that could become potential agenda items. Step 2 Planning the project. When adding an item to its work agenda, the IASB considers whether to conduct the project alone or jointly with another standard setter. A working group is usually formed at this stage and the project plan is developed. 22 | THE FINANCIAL REPORTING ENVIRONMENT Step 3 Developing and publishing the discussion paper. It is not mandatory for the IASB to issue a discussion paper in the development of a standard, but it is usual practice where there is a major new topic being developed and the IASB wish to set out their position and invite comments at an early stage in the process. Typically, a discussion paper includes:  a comprehensive overview of the issue;  possible approaches in addressing the issue;  the preliminary views of its authors or the IASB; and  an invitation to comment. Step 4 Developing and publishing the exposure draft. This is a mandatory step in the due process. Regardless of whether a discussion paper has been published, the exposure draft is the IASB's main means of consulting the public on the proposed standard. The exposure draft sets out the proposed standard in detail. The development of the exposure draft begins with the IASB considering the following:  issues on the basis of staff research and recommendations;  comments received on the discussion paper (if one was published); and  suggestions made by the IFRS Advisory Council, working groups, other standard-setters and public meetings where the proposed standard was discussed. Once the exposure draft has been published the IASB again invites comments. Step 5 Developing and publishing the standard. The development occurs at IASB meetings when the IASB considers the comments received on the exposure draft. The IASB must then consider whether a second exposure draft should be published. The IASB needs to:  identify substantial issues that emerged during the comment period on the exposure draft that it had not previously considered;  assess the evidence that has been considered;  evaluate whether it has sufficiently understood the issues and obtained the views of constituents; and  consider whether the various viewpoints were aired in the exposure draft and adequately discussed and reviewed in the basis for conclusions. If the IASB decides that the exposure draft should be republished then the same process should be followed as for the first exposure draft. Once the IASB is satisfied that the issues raised have been dealt with, the IFRS is drafted. Step 6 After the standard is issued. After an IFRS is issued, IASB holds regular meetings with interested parties, including other standard-setting bodies, to help understand unanticipated issues related to the practical implementation and potential impact of its proposals. If there are concerns about the quality of the standard from the IFRS Advisory Council, the IFRS Interpretations Committee, standard-setters and constituents, then the issue may be added to the IASB agenda and the process reverts back to Step 1. Post-implementation reviews are carried out for each new standard, generally after the requirements have been applied for two years internationally.  FINANCIAL ACCOUNTING AND REPORTING | 23 The standard setting process can be illustrated in the diagram below: Research Discussion paper (DP) optional MODULE 1 Public consultation Proposal Extensive outreach activities Exposure draft (ED) Input into standard setting process Public Consultation Published Feedback IFRS statement IASB post-implementation review 5.6 CONSULTATION WITH NATIONAL STANDARD-SETTERS The development of an IFRS involves an open, public process of debating technical issues and evaluating input sought through several mechanisms. Opportunities for interested parties to participate in the development of IFRS would include, depending on the nature of the project:  participation in the development of views as a member of the IFRS Advisory Council;  participation in advisory groups;  submission of a comment letter in response to a discussion document;  submission of a comment letter in response to an Exposure Draft;  participation in public hearings; and/or  participation in field visits and field tests. The IASB publishes an annual report on its activities during the past year and priorities for next year. This report provides a basis and opportunity for comment by interested parties. In addition, it also undertakes a public consultation on its future technical agenda every three years. The first of these public consultations took place in the second half of 2011 and the second public consultation was in August 2015. The IASB reports on its technical projects on its website. It also publishes a report on IASB decisions immediately after each IASB meeting in its newsletter IASB Update. 5.7 THE NEED FOR INTERNATIONAL STANDARDS Although the predecessor organisation of the IFRS Foundation was set up in the 1970s, the development of International standards has grown in importance in the last 10 years. As business and commerce became more global in nature, many interested parties began to understand the need for a common set of accounting standards. Until that point, many multinational companies prepared financial statements under a variety of GAAPs, which was costly. This also had an impact on the auditors of those financial statements and current and future investors. Companies with stock exchange listings in more than one jurisdiction had to prepare different sets of financial statements for each jurisdiction which was viewed as inefficient.  24 | THE FINANCIAL REPORTING ENVIRONMENT The original International Accounting Standards were deliberately drafted to be flexible and to allow choices. From the 1990s onwards it became increasingly clear that it was not enough to have a set of international standards with which most countries could comply. These standards had to be sufficiently rigorous to be acceptable to all stock exchanges, including those in the US. The starting point for the rapid change of the last few years was the acceptance of international accounting standards for cross border listings by the International Organisation of Securities Commissions (IOSCO). International standards gained more prominence when the European Union decided that from 2005, the consolidated financial statements of companies in the member states would be prepared under international standards. IFRS became the global standards that were needed and since then many countries, including Australia and South Africa, have adopted IFRS as their national standards or have a program in place to adopt international standards in the near future. 5.7.1 BENEFITS OF HARMONISATION There are several general benefits of harmonisation:  Investors and lenders, both individual and corporate, need to be able to compare the financial results of different companies internationally as well as nationally in making investment decisions. Differences in accounting practice and reporting can prove to be a barrier to such cross-border analysis. Harmonisation of financial reporting benefits investors, lenders and their advisors, because it provides them with better quality information on which to base economic decisions. Users no longer have to understand several different national GAAPs or to incur the costs of adjusting financial statements in order to compare them with each other.  Harmonisation benefits the global economy, because it makes it removes barriers to the flow of capital between countries. It is easier for businesses to expand into and raise finance in countries other than their own.  Robust international financial reporting standards are also needed to protect investors and to restore public confidence in financial reporting following the failure of several banks (notably Lehman Brothers in 2008) and the resulting 'credit crunch' and global financial crisis. One of the actions agreed upon by the G-20 leaders (finance ministers and central bank governors from the world's largest economies), in their summit meetings after the crisis, was that the key global accounting standards bodies should work intensively towards the objective of creating a single set of high quality global standards. A full list of countries adopting IFRS and their progress can be found on: www.iasplus.com/en/resources/ifrs-topics We look at the harmonisation process in more detail later in this module. 5.7.2 BARRIERS TO HARMONISATION There are undoubtedly many barriers to full international harmonisation. Problems include the following:  Different purposes of financial reporting. In some countries the purpose is solely for tax assessment, while in others it is for investor decision-making.  Different legal systems. These may prevent the development of certain accounting practices and restrict the options available.  Different user groups. Countries have different ideas about who are the relevant user groups and their respective importance. In the US investor and creditor groups are given prominence, while in Europe employees enjoy a higher profile.  Needs of developing countries. Developing countries are clearly behind in the standard-setting process and they need to develop the basic standards and principles already in place in most developed countries.  Nationalism is demonstrated in an unwillingness to accept another country's standard.  Cultural differences result in objectives for accounting systems differing from country to country.  FINANCIAL ACCOUNTING AND REPORTING | 25  Unique circumstances. Some countries may be experiencing unusual circumstances which affect all aspects of everyday life and impinge on the ability of companies to produce proper reports, for example, hyperinflation, civil war, currency restriction and so on.  The lack of strong accountancy bodies. Many countries do not have strong independent accountancy or business bodies which would press for better standards and greater harmonisation. These are difficult problems to overcome, and yet attempts are being made continually to do so. We MODULE 1 must therefore consider what the perceived advantages of harmonisation are, which justify so much effort. 5.8 BENEFITS OF IFRS FOR NATIONAL JURISDICTIONS The advantages of IFRS described above apply to individual nations. If it is possible to compare the financial statements of an entity in one country with those of another entity located in a different country it becomes easier to do business with overseas companies. This benefits national economies, as well as the global economy. In its 2002 policy statement International Convergence and Harmonisation Policy the Australian Accounting Standards Board listed the following additional benefits of adopting IFRS:  increasing the understanding by foreign investors of Australian financial reports;  reducing financial reporting costs for Australian multinational companies and foreign companies operating in Australia and reporting elsewhere;  facilitating more meaningful comparisons of the financial performance and financial position of Australian and foreign public sector reporting entities; and  improving the quality of financial reporting in Australia to best international practice. There are a number of further potential benefits for national jurisdictions:  Many developing nations who do not have the resources to develop and implement their own national standards can adopt IFRS as a full set of standards. This is perhaps more relevant since the issue of the IFRS for SMEs as previously the level of detail in standards and the amount of disclosure required was a barrier to adoption of IFRS in developing countries.  It may be easier for national governments to control the activities of foreign multinational companies that carry out operations within their territory. These companies would not be able to 'hide' behind foreign accounting practices which are difficult to understand.  Tax authorities may find it easier to calculate the tax liability of investors. Many national standard setting bodies are experiencing a change in their role as IFRS have become more important. Many standard setters no longer develop and issue their own accounting standards and instead comment on the work of the IASB, the impact of new IFRS and changes to existing IFRS on their home jurisdiction. National standard setting bodies may also undertake research on behalf of the IASB on particular projects. 5.9 OTHER INTERNATIONAL INFLUENCES There are a number of other international bodies that have been involved in the recent trend of moving to IFRS. They are discussed briefly below. 5.9.1 IASB AND THE EUROPEAN COMMISSION The European Commission (EC) has acknowledged the role of the IASB in harmonising world-wide accounting rules and EC representatives attend IASB Board meetings and have joined Steering Committees involved in setting IFRS. The EC has also set up a committee to investigate where there are conflicts between European Union norms and International Standards so that compatibility can be achieved. In turn, the IASB has used EC Directives in its work. From 2005, all listed entities in member states have been required to use IFRS in their consolidated financial statements.  26 | THE FINANCIAL REPORTING ENVIRONMENT 5.9.2 UNITED NATIONS (UN) The UN has a Commission and Centre on Transnational Reporting Corporations through which it gathers information concerning the activities and reporting of multinational companies. The UN processes are highly political and probably reflect the attitudes of the governments of developing countries towards multinationals. For example, there is an inter-governmental working group of 'experts' on international standards of accounting and reporting which is dominated by the non-developed countries. 5.9.3 INTERNATIONAL FEDERATION OF ACCOUNTANTS (IFAC) The IFAC is a private sector body established in 1977 and which now consists of over 100 professional accounting bodies, including CPA Australia, from around 80 different countries. The IFAC's main objective is to coordinate the accounting profession on a global scale by issuing and establishing International Standards on auditing, management accounting, public sector accounting, ethics, education and training. The IFAC has separate committees working on these topics and also organises the World Congress of Accountants, which is held every four years. 5.9.4 ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT (OECD) The OECD was established in 1960 by the governments of 21 countries to 'achieve the highest sustainable economic growth and employment and a rising standard of living in member countries while maintaining financial stability and, thus, to contribute to the world economy'. It now has 35 member countries. The OECD's aim is to bring together the governments of countries committed to democracy and the market economy from around the world to:  support sustainable economic growth;  boost employment;  raise living standards;  maintain financial stability;  assist other countries' economic development; and  contribute to growth in world trade. The Organisation provides a setting where governments compare policy experiences, seek answers to common problems, identify good practice and coordinate domestic and international policies. The OECD supports the work of the IASB but also undertakes its own research into accounting standards via ad hoc working groups. The OECD also produces its own corporate governance principles and other publications aimed at improving financial reporting, regulation and removing corruption. 5.9.5 AUSTRALIAN ACCOUNTING STANDARDS BOARD (AASB) The AASB is an independent accounting standard setting body based in Melbourne. The functions of the AASB under the Australian Securities and Investments Commission (ASIC) 2001 Act are:  to develop a conceptual framework, not having the force of an accounting standard, for the purpose of evaluating proposed accounting standards and international standards;  to make accounting standards under section 334 of the Corporations Act 2001 for the purposes of the corporations legislation (other than the excluded provisions);  to formulate accounting standards for other purposes;  to participate in and contribute to the development of a single set of accounting standards for worldwide use; and  to advance and promote the main objects of Part 12 of the Australian Securities and Investments Commission Act, with regard to the interests of Australian corporations which raise or propose to raise capital in major international financial centres.  FINANCIAL ACCOUNTING AND REPORTING | 27 The mission of the AASB is to:  develop and maintain a high-quality conceptual framework for all sectors of the Australian economy;  develop and maintain high quality accounting (i.e. financial reporting) standards for reporting entities in those sectors; and  contribute, through thought leadership and participation, in the development of global financial MODULE 1 reporting standards and standard-setting. The Australian process of harmonisation with IFRS has been to issue IFRS-equivalent standards, that is, adopt the content of IFRS with minor changes made to refer to the Australian legislative environment. The audit report of a company's financial statements states that they have been prepared in compliance with IFRS. The AASB issues standards that apply to both for-profit and not-for-profit entities. Standards issued by the International Accounting Standards Committee (IASC), the predecessor of the IASB, are designated as IAS 1, IAS 2 etc. The Australian equivalents are AASB 101, AASB 102 etc. Standards issued by the IASB are designated as IFRS 1, IFRS 2 etc, and the Australian equivalents are AASB 1, AASB 2 etc. 5.10 TRUE AND FAIR VIEW/FAIR PRESENTATION It is a requirement of national legislation in some countries that the financial statements should give a true and fair view of (or 'present fairly, in all material respects') the financial performance and position of the entity as at the end of the financial year. Despite this, the terms 'true and fair view' and 'present fairly, in all material respects' are not defined in accounting or auditing standards. In some jurisdictions a company's managers may depart from any of the provisions of accounting standards if these are inconsistent with the requirement to give a true and fair view. This is commonly referred to as the 'true and fair override'. It has been treated as an important loophole in the law in different countries and has been the cause of much argument and dissatisfaction within the accounting profession. For example, it is not recognised in Australia, where it was removed from legislation in 1991. Australian regulators and bodies want the accounting standards (and the true and fair view being established by them) given primacy. In Australia therefore, directors are required to provide additional information in order to comply with the true and fair view, as they cannot depart from any of the provisions of the accounting standards. 5.11 THE IASB AND CURRENT ACCOUNTING STANDARDS The IASB's predecessor body, the IASC, had issued 41 International Accounting Standards (IASs) and on 1 April 2001 the IASB adopted all of these standards and now issues its own International Financial Reporting Standards (IFRS). So far 17 new IFRS have been issued as well as the IFRS for small and medium-sized enterprises (SMEs). From now on in this Study guide we will use the phrase 'IFRS' for all International Accounting Standards unless we are specifically discussing a particular IAS. 5.12 THE IASB AND FASB The IASB and the US Financial Accounting Standards Board (FASB) have been working together since 2002 to achieve convergence of IFRS and US GAAP. Both parties set out their agreement in a Memorandum of Understanding known as the Norwalk Agreement. Their work plan was set out in a roadmap for convergence which outlined their targets over the period up to 2008 (see also later in this module). In 2007, the US Securities and Exchange Commission (SEC) removed the necessity for a reconciliation between IFRS and US GAAP for non-US companies that were listed in the US providing their financial statements complied with IFRS. The SEC originally planned to phase in allowing all companies to use IFRS by 2014. This has not happened and the SEC are currently considering whether a single set of global accounting standards is achievable. 28 | THE FINANCIAL REPORTING ENVIRONMENT In 2008, and again in 2010, the Memorandum of Understanding was updated, setting out the objectives for the period to 2011 in the convergence of US GAAP and IFRS. The IASB and the FASB set a June 2011 target date for those projects deemed to be most important, leaving those with a lesser degree of importance to be dealt with later. The following projects were completed in June 2011:  Business combinations;  Consolidation;  Derecognition of financial instruments;  Fair value measurement;  Financial statement presentation;  Joint arrangements; and  Post-employment benefits. They published a joint progress report in 2012 on progress made on financial instruments, and in 2013 they issued a high level update on the status and timeline of the remaining projects. Since this, the IASB and FASB have worked together on the following projects:  Financial instruments;  Revenue;  Leases; and  Insurance contracts. These projects have now been completed although the pace of these projects has slowed down. The IASB has also worked with the FASB to develop a common conceptual framework. This is intended to provide a sound foundation for developing future accounting standards. The IASB Conceptual Framework for Financial Reporting is discussed later in this module and you will see that FASB have withdrawn from this project. This could begin to cast doubt over the future relationship between IASB and FASB.  FINANCIAL ACCOUNTING AND REPORTING | 29 KEY MODULE POINTS 1  Accounting is the process of recording, analysing and summarising transactions of a business and communicating that information to decision makers.  A business is an entity which exists to make a profit. MODULE 1  There are three main types of business entity: sole traders, partnerships and limited liability companies.  Not-for-profit entities such as charities and clubs may also prepare accounts.  Financial reporting is the process of classifying, recording and presenting financial data in accordance with generally established concepts and principles.  There are various groups of people who need information about the activities of a business.  The regulatory framework is the most important element in ensuring that general purpose financial reporting produces relevant and reliable information and therefore meets the needs of shareholders, lenders and other users.  As the IASB has no power to regulate the use of IFRS, regulation takes place at a national level.  The organisational structure for International financial reporting consists of: – the IFRS Foundation; – the IASB; – the IFRS Advisory Council; and – the IFRS Interpretations Committee.  IFRS are developed through a formal system of due process and broad international consultation involving accountants, financial analysts and other users and regulatory bodies from around the world.  There are a number of benefits of harmonisation including the facilitation of cross-border investment and financing.  The move toward the use of IFRSs has been influenced by a number of international bodies.  It is a requirement of national legislation in some countries that the financial statements should give a true and fair view. However the term 'true and fair view' is not defined in accounting or auditing standards. 30 | THE FINANCIAL REPORTING ENVIRONMENT QUICK REVISION QUESTIONS 1 1 What is the main aim of accounting? A To produce a trial balance B To record every financial transaction individually C To maintain ledger accounts for every asset and liability D To provide financial information to users of such information 2 Which of the following groups of users would primarily be interested in a company's annual published financial statements? A Shareholders and suppliers B Management and employees C Shareholders and providers of finance D General public, environmental pressure groups 3 Are the following statements correct or incorrect?  The shareholder is only interested in a statement of financial prospects, that is, an indication of future progress.  The supplier of goods on credit is only interested in a statement of financial position, that is, an indication of the current state of affairs. Shareholder Supplier A Correct Correct B Correct Incorrect C Incorrect Correct D Incorrect Incorrect 4 Which of the following statements concerning the International Accounting Standards Board (IASB) is correct? I. It develops and ultimately issues International Financial Reporting Standards (IFRSs). II. The IASB is accountable to the IFRS Foundation. A I only B II only C Both I and II D Neither I nor II 5 Which of the following statements is correct? A The IASB appoints the Trustees of the IFRS Foundation. B The IFRS Foundation develops and issues Interpretations. C The IFRS Interpretations Committee oversees the work of the IFRS Foundation. D The IFRS Advisory Council assists and advises the IASB in the process of developing IFRSs. 6 Which of these statements are correct? I. The IASB has the objective of enforcing IFRS. II. The IASB is responsible for developing and issuing IFRS. A I only B II only C Both I and II D Neither I nor II  FINANCIAL ACCOUNTING AND REPORTING | 31 7 Which committee of the IASB provides guidance on the application of IFRS? A IFRS Foundation B IFRS Advisory Council C IFRS Interpretations Committee D International Accounting Standards Committee 8 What is the correct definition of GAAP? MODULE 1 A National accounting standards and company law B National accounting standards, stock exchange rules and company law C International accounting standards, company law and stock exchange rules D National accounting standards, international accounting standards, stock exchange rules and company law 9 Which of the following is an advantage of a company that prepares a set of financial statements under the regulatory framework? A Lower costs of producing financial information B Higher quality financial information is produced C More financial information available for competitors D Less disclosure of a company's activities in financial statements 10 What is the correct order for the process of issuing a new IFRS by the IASB? A Discussion Paper, Standard B Exposure Draft, Discussion Paper, Review C Exposure Draft, Discussion Paper, Standard D Discussion Paper, Exposure Draft, Standard  32 | THE FINANCIAL REPORTING ENVIRONMENT 6 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) LO 1.6 Section overview  The rules, from whatever source, which govern accounting. 6.1 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) We defined GAAP earlier in this module as all of the rules, from whatever source, which govern accounting. There are different views of GAAP in different countries. The UK position can be explained in the following extracts from UK GAAP (Davies, Paterson & Wilson, Ernst & Young, 5th edition). Our view is that GAAP is a dynamic concept which requires constant review, adaptation and reaction to changing circumstances. We believe that use of the term "principle" gives GAAP an unjustified and inappropriate degree of permanence. GAAP changes in response to changing business and economic needs and developments. As circumstances alter, accounting practices are modified or developed accordingly … We believe that GAAP goes far beyond mere rules and principles, and encompasses contemporary permissible accounting practice. It is often argued that the term "generally accepted" implies that there must exist a high degree of practical application of a particular accounting practice. However, this interpretation raises certain practical difficulties. For example, what about new areas of accounting which have not, as yet, been generally applied? What about different accounting treatments for similar items – are they all generally accepted? It is our view that "generally accepted" does not mean "generally adopted or used". We believe that, in the UK context, GAAP refers to accounting practices which are regarded as permissible by the accounting profession. The extent to which a particular practice has been adopted is, in our opinion, not the overriding consideration. Any accounting practice which is legitimate in the circumstances under which it has been applied should be regarded as GAAP. The decision as to whether or not a particular practice is permissible or legitimate would depend on one or more of the following factors:  Is the practice addressed either in the accounting standards, statute or other official pronouncements?  If the practice is not addressed in UK accounting standards, is it dealt with in International Accounting Standards, or the standards of other countries such as the US?  Is the practice consistent with the needs of users and the objectives of financial reporting?  Does the practice have authoritative support in the accounting literature?  Is the practice being applied by other companies in similar situations?  Is the practice consistent with the fundamental concept of 'true and fair'? This view is not held in all countries. In the US particularly, the equivalent of a 'true and fair view' is 'fair presentation in accordance with GAAP'. Generally Accepted Accounting Principles are defined as those principles which have 'substantial authoritative support'. Therefore, accounts prepared in accordance with accounting principles for which there is not substantial authoritative support are presumed to be misleading or inaccurate. The effect here is that 'new' or 'different' accounting principles are not acceptable unless they have been adopted by the mainstream accounting profession, usually the standard-setting bodies and/or professional accountancy bodies. This is much more rigid than the UK view expressed above.  FINANCIAL ACCOUNTING AND REPORTING | 33 In contrast, however, in Australia there does not seem to be any strong body of opinion on GAAP. GAAP is only used by Australian companies if they need to prepare financial statements to US standards in order to raise funds from, or obtain a listing, in the US. Otherwise, Australian companies implement IFRS and the pronouncements of the IASB and AASB. 7 CONCEPTUAL FRAMEWORK MODULE 1 Section overview  The Conceptual Framework provides the theoretical framework for the development of IFRS. 7.1 THE SEARCH FOR A CONCEPTUAL FRAMEWORK A conceptual framework is a statement of generally accepted theoretical principles which form the frame of reference for financial reporting. The financial reporting process is concerned with providing information that is useful in the business and economic decision-making process. Therefore, a conceptual framework forms the theoretical basis for determining which events should be accounted for, how they should be measured and how they should be communicated to the user. 7.1.1 THE NEED FOR A CONCEPTUAL FRAMEWORK Definitions Conceptual framework: A coherent system of interrelated objectives and fundamental concepts that prescribes the nature, function and limits of financial accounting and reporting. (FASB) Conceptual framework: A coherent system of concepts that flow from an objective. The objective of financial reporting is the foundation of the framework. The other concepts provide guidance on identifying the boundaries of financial reporting, selecting the transactions, other events and circumstances to be represented; how they should be recognised and measured (or disclosed); and how they should be summarised and communicated in financial reports. (IASB) A conceptual framework is an important part of the financial reporting system as it underpins the development of accounting standards and sets out the basis of recognition of items in the financial statements such as assets, liabilities, income and expenses. It provides the basis for the development of new accounting standards and the evaluation of those already in existence. Where an agreed framework exists, the standard-setting body acts as an architect or designer, building accounting rules on the foundation of sound, agreed basic principles. 7.1.2 ADVANTAGES AND DISADVANTAGES OF A CONCEPTUAL FRAMEWORK Advantages  The situation is avoided whereby standards are developed on a piecemeal basis as a reaction to a particular accounting problem which has emerged. In this situation, resources may be channelled into standardising accounting practice in that area, without regard to whether that particular issue is necessarily the most important issue at that time. Standards developed in this way may be inconsistent with basic concepts and with each other.  The situation is also avoided where there are significant 'gaps' and certain topics are never addressed. For example, before the development of the IASB's and the US FASB's conceptual frameworks there were no formal definitions of terms such as 'asset', 'liability' or 'equity'.  34 | THE FINANCIAL REPORTING ENVIRONMENT  The development of certain standards (particularly national standards) has been subject to considerable political interference from interested parties. Where there is a conflict of interest between user groups on which policies to choose, policies deriving from a conceptual framework will be less open to criticism that the standard-setter acceded to external pressure.  The existence of a framework of principles means that it is much harder for preparers to avoid complying with reporting requirements. Rules can be avoided, but preparers must apply the 'spirit' and reasoning behind standards based on principles.  Standard setters may become more accountable to the users of financial statements, because the reasoning behind specific standards should be clear. It should also be clear to users when standard setters have departed from the principles set out in the framework.  The process of developing standards should be easier and less costly because the basic principles that underpin them have already been debated and established.  Business is becoming increasingly complex. Accounting standards cannot cover all eventualities and in practice the development of standards has lagged behind the growth in particular types of complex transaction (for example, in 'off balance sheet' finance). A conceptual framework provides principles that can be applied where there is no relevant accounting standard or other guidance.  The existence of a conceptual framework contributes to the general credibility of financial reporting and increases public confidence in financial statements. Disadvantages  Financial statements are intended for a variety of users, and it is not certain that a single conceptual framework can be devised which will suit all users.  Given the diversity of user requirements, there may be a need for a variety of accounting standards, each produced for a different purpose (and with different concepts as a basis).  It is not clear that a conceptual framework makes the task of preparing and then implementing standards any easier than without a framework.  In practice, conceptual frameworks can lead to accounting standards which are very theoretical and academic. They may increase the complexity of financial information and lead to solutions that are conceptually pure but are difficult to understand and apply for many preparers and users.  Conceptual frameworks tend to focus on the usefulness of financial information in making 'hold or sell' decisions about an investment. However, many users of financial statements are also interested in information that will help them assess the stewardship of management.  In addition, accounting principles focus only on economic phenomena: transactions that can be expressed in money terms. Many believe that other aspects of an entity's operations, such as its effect on the natural environment or on the wider community, should be at least equally important in assessing its performance and making investment decisions. Before we look at the IASB's attempt to produce a conceptual framework, we need to consider another element of importance to this debate: Generally Accepted Accounting Principles or GAAP. 7.2 THE CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING 2018 7.2.1 INTRODUCTION The introduction to the Conceptual Framework points out the fundamental reason why financial statements are produced worldwide, that is, to satisfy the requirements of external users, but that practice varies due to the individual pressures in each country. These pressures may be social, political, economic or legal, but they result in variations in practice from country to country, including the form of statements, the definition of their component parts (assets, liabilities, equity, income, expenses), the criteria for recognition of items and both the scope and disclosure of financial statements. The IASB wishes to narrow these differences by harmonising all aspects of financial statements, including the regulations governing their accounting standards and their preparation and presentation.  FINANCIAL ACCOUNTING AND REPORTING | 35 The introduction emphasises the way financial statements are used to make economic decisions. The Conceptual Framework was revised in March 2018 and is effective for periods commencing on or after 1 January 2020. It consists of several sections or chapters as follows:  Chapter 1 – The objective of general purpose financial reporting (see below);  Chapter 2 – Qualitative characteristics of useful financial information (see below);  Chapter 3 – Financial statements and the reporting entity (see Module 3); MODULE 1  Chapter 4 – The elements of the financial statements (see below);  Chapter 5 – Recognition and derecognition of the elements of the financial statements (see below);  Chapter 6 – Measurement of the elements of the financial statements (see Module 2);  Chapter 7 – Presentation and disclosure (see Module 3);  Chapter 8 – Concepts of capital and capital maintenance (see Module 2). Question 5: Economic decisions Financial statements provide information that helps users to make economic decisions. What are the main types of economic decision for which financial statements are likely to be used? (The answer is at the end of the module.) 7.2.2 PURPOSE AND STATUS The purposes of the Conceptual Framework are to:  assist the International Accounting Standards Board (Board) to develop IFRS Standards (Standards) that are based on consistent concepts;  assist preparers to develop consistent accounting policies when no Standard applies to a particular transaction or other event, or when a Standard allows a choice of accounting policy; and  assist all parties to understand and interpret the Standards. The IASB's Conceptual Framework for Financial Reporting (Conceptual Framework) is, in effect, the theoretical framework upon which all IFRS are based and therefore determines how financial statements are prepared and the information they contain. The Conceptual Framework itself is not an International Financial Reporting Standard and so does not overrule any individual IFRS. It acts to provide guidance in the absence of regulation and to provide a consistent basis for developing and revising IFRSs. In the rare cases of conflict between an IFRS and the Conceptual Framework, the IFRS will prevail. These cases will diminish over time to the extent that the Conceptual Framework is used as a guide in the production of future IFRS. The Conceptual Framework itself will be revised occasionally depending on the experience of the IASB in using it. 7.2.3 SCOPE The Conceptual Framework is concerned with general purpose financial reporting. The term is not defined or discussed in the Conceptual Framework, but generally means a normal set of annual financial statements or published annual report available to users outside the reporting entity. A reporting entity is an entity that is required, or chooses, to prepare financial statements. A reporting entity can be a single entity or a portion of an entity or can comprise more than one entity. A reporting entity is not necessarily a legal entity.  36 | THE FINANCIAL REPORTING ENVIRONMENT 7.3 THE OBJECTIVE OF GENERAL PURPOSE FINANCIAL REPORTING These decisions involve:  buying, selling or holding equity and debt instruments (such as loan stock or debentures);  providing or settling loans and other forms of credit: or  exercising rights to vote on, or otherwise influence, management's actions that affect the use of the entity's economic resources. The Conceptual Framework explains that existing and potential investors, lenders and other creditors must normally rely on general purpose financial reports for most of the financial information that they need. Therefore they are the primary users to which general purpose financial reports are directed. General purpose financial reports cannot provide all the information that existing and potential investors, lenders and other creditors need. They may also need to consider relevant information from other sources, for example, general economic conditions and expectations, political events and information about the industry in which the company operates. Financial statements do not provide a valuation of an entity, but should allow primary users sufficient information to form their own opinions and estimations. Financial statements contain elements of estimation and judgements made by the directors and management, and the Conceptual Framework sets out the key concepts underlying these judgements. The information provided by the financial statements should include detail about the entity's economic resources, claims against the entity and changes in resources and claims. This will enable users to assess how the management is running the business ('management's stewardship') users, such as creditors and lenders, can use the information to assess the entity's potential to fund future cash flows, for example a bank loan. The Conceptual Framework makes it clear that this information should be prepared using accrual accounting. The Conceptual Framework explains that other users, such as regulators and members of the public may also find general purpose financial reports useful. However, financial reports are not primarily prepared for these groups of users. Question 6: Users of financial information Earlier in this module, we discussed the users of accounting information. List the nine groups of users and describe the information needs of each group. (The answer is at the end of the module.) 7.3.1 ECONOMIC RESOURCES, CLAIMS AND CHANGES IN RESOURCES AND CLAIMS Financial reports provide information about the financial position of an entity:  its economic resources; and  the claims against it. They also provide information about changes in an entity's economic resources and claims. In other words, financial reports provide information about an entity's assets (which will generate economic benefits in future) and liabilities (which will deplete economic benefits in future) in order to determine the net position (assets minus liabilities) and how that net position changes. Information about the entity's economic resources and the claims against it helps users to assess the entity's liquidity and solvency, its needs for additional finance and how successful it is likely to be in obtaining it.  FINANCIAL ACCOUNTING AND REPORTING | 37 Definitions Liquidity. The availability of sufficient funds to meet short-term financial commitments as they fall due. Solvency. The availability of cash over the longer term to meet financial commitments as they fall due. Changes in an entity's economic resources and claims result from its financial performance and also MODULE 1 from other transactions and events such as the issue of shares or an increase in debt (borrowings). Information about a reporting entity's financial performance helps users to understand the return that the entity has produced on its economic resources. This is an indicator of how efficiently and effectively management has used the resources of the entity and is helpful in predicting future returns. Information about an entity's financial performance helps users to assess the entity's past and future ability to generate net cash inflows from its operations. Information about a reporting entity's cash flows during a period also helps users assess the entity's ability to generate future net cash inflows and provides information about factors that may affect its liquidity or solvency. It also gives users a better understanding of the entity's operations and of its financing and investing activities. 7.4 THE REPORTING ENTITY The IASB acknowledges that it does not have authority to determine who must or should prepare financial statements, but it provides general guidance in paragraph 3.10 of The Conceptual Framework for Financial Reporting (Conceptual Framework): A reporting entity is an entity that is required, or chooses, to prepare financial statements. A reporting entity can be a single entity or a portion of an entity or can comprise more than one entity. A reporting entity is not necessarily a legal entity. General purpose financial reports are often needed as a result of regulatory requirements, especially from entities who trade equities or have issued debt instruments in a public market. These reports will typically be produced using IFRSs. The IASB makes it clear that general purpose financial reports are not limited to legal entities, a reporting entity could take many forms including for example a proportion of an entity or a not-for-profit entity. A reporting entity would exist if the entity has existing and potential investors, lenders and other creditors who would rely on general purpose financial reports for information they need to make decisions about providing resources to the entity. For-profit private sector entities in Australia must prepare general purpose financial statements when they have both public accountability and they are required by legislation to comply with Australian Accounting Standards. Public accountability arises when an entity has or is in the process of issuing debt or equity instruments (i.e. securities) that are traded in a public market or it holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses. This would include for example, insurance companies, banks and mutual funds (AASB 1053, Appendix A). Other Australian entities who do not meet the above criteria may issue non-general purpose financial statements. These reports would be prepared and