THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

OF PAKISTAN (ICPAP)
(Suggested Solution)

Stage Skills Course Code S-403

Examination Summer-2012 Course Name Financial and Corporate Reporting
Time Allowed 03 Hours Maximum Marks 100
NOTES:
1) All questions are to be attempted.
2) Answers are expected to the precise, to the point and well written.
3) Neatness and style will be taken into account in marking the papers.

Question No 1:-

Below are the summarised statements of financial position for three companies
as at 31 March 2009:

Pacemaker Shield Video Tech

Assets Rs Rs Rs Rs Rs Rs
million million million million million million
Non-current assets
Property, plant and 520 280 240
equipment
Investments 345 40 Nil
865 320 240
Current assets
Inventory 142 160 120
Trade receivables 95 88 50
Cash and bank 8 245 22 270 10 180
Total assets 1,110 590 420
Equity and liabilities
Equity shares of Rs1 each 500 145 100
Share premium 100 Nil Nil
Retained earnings 130 230 260 260 240 240
730 405 340
Non – current liabilities
10% loan notes 180 20 Nil
Current liabilities 200 165 80
Total equity and liabilities 1,110 590 420
Notes:

Pacemaker is a public listed company that acquired the following investments:

i. Investment in Shield

On 1 April 2007 Pacemaker acquired 116 million shares in Shield for an

immediate cash payment of Rs210 million and issued at par one 10%
Rs100 loan note for every 200 shares acquired. Shield’s retainedearnings at
the date of acquisition were Rs120 million.

ii. Investment in Video Tech

On 1 October 2008 Pacemaker acquired 30 million shares in Video Tech in

exchange for 75 million of its ownshares. The stock market value of
Pacemaker’s shares at the date of this share exchange was Rs1.60
each.Pacemaker has not yet recorded the investment in Video Tech.

iii. Pacemaker’s other investments, and those of Shield, are available-for-sale

investments which are carried at their fair values as at 31 March 2008. The
fair value of these investments at 31 March 2009 is Rs82 million and Rs37
million respectively.

Other relevant information:

iv. Pacemaker’s policy is to value non-controlling interests at their fair values.

The directors of Pacemaker assessedthe fair value of the non-controlling
interest in Shield at the date of acquisition to be Rs65 million.

There has been no impairment to goodwill or the value of the investment

in Video Tech.

v. At the date of acquisition of Shield owned a recently built property that

was carried at its (depreciated) construction cost of Rs62 million. The fair
value of this property at the date of acquisition was Rs82 million and ithad
an estimated remaining life of 20 years.

For many years Shield has been selling some of its products under the
brand name of ‘Kyklop’. At the date ofacquisition the directors of
Pacemaker valued this brand at Rs25 million with a remaining life of 10
years. Thebrand is not included in Shield’s statement of financial position.
 The fair value of all other identifiable assets and liabilities of Shield were
equal to their carrying values at thedate of its acquisition.

vi. The inventory of Shield at 31 March 2009 includes goods supplied by

Pacemaker for Rs56 million (at selling price from Pacemaker). Pacemaker
adds a mark-up of 40% on cost when selling goods to Shield. There are
nointra-group receivables or payables at 31 March 2009.
vii. Video Tech’s profit is subject to seasonal variation. Its profit for the year
ended 31 March 2009 was Rs100 million. Rs20 millions of this profit was
made from 1 April 2008 to 30 September 2008.
viii. None of the companies have paid any dividends for many years.

Required:

Prepare the consolidated statement of financial position of Pacemaker as at

31 March 2009.

Answer No 1:-

Consolidated statement of financial position of Pacemaker as at 31 March

2009:

Rs Rs
million million
Non-current assets
Tangible
Property, plant and equipment (w (i)) 818
Intangible
Goodwill (w (ii)) 23
Brand (25 – 5 (25/10 x 2 years post acq amortization)) 20
Investments
Investment in associate (w (iii)) 144
Other available-for-sale investments (82 + 37) 119
1,124
Current assets
Inventory (142 + 160 – 16 URP (w (iv))) 286
Trade receivables (95 + 88) 183
Cash and bank (8 + 22) 30 499
Total assets 1,623
Equity and liabilities
Equity attributable to the parent
Equity shares (500 + 75 (w (iii))) 575
Share premium (100 + 45 (w (iii)) 145
Retained earnings (w (iv)) 247 392
967
Non-controlling interest (w (v)) 91
Total equity 1,058
Non-current liabilities
10% loan notes (180 + 20) 200
Current liabilities (200 + 165) 365
Total equity and liabilities 1,623

Workings (all figures in Rs million)

The investment in Shield represents 80% (116/145) of its equity and is likely
to give Pacemaker control thus Shield should beconsolidated as a subsidiary.
The investment in Video Tech represents 30% (30/100) of its equity and is
normally treated as anassociate that should be equity accounted.

i.

Property, plant and equipment

Pacemaker 520
Shield 280
Fair value property (82-62) 20
Post – acquisition depreciation (2 year) (20 ×2/20 years) (2)
818
ii.

Goodwill in Shield:
Investment at cost – cash 210
– loan note (116/200 x Rs100) 58
Cost of the controlling interest 268
Fair value of non-controlling interest (from question) 65
Equity shares 145
Pre-acquisition profit 120
Fair value adjustments – property (w (i)) 20
– brand 25
Fair value of net assets at acquisition (310)
Goodwill 23
iii. Investment in associate:

Rs million
Investment at cost (75 x Rs1.60) 120
Share of post-acquisition profit (100 – 20) x 30% 24
 144
The purchase consideration by way of a share exchange (75 million shares
in Pacemaker for 30 million shares in Video Tech)would be recorded as an
increase in share capital of Rs75 million (Rs1 nominal value) and an
increase in share premium of Rs45 million (75 million x Rs0.60).

iv.

Consolidated retained earnings:

Pacemaker’s retained earnings 130
Shield’s post-acquisition profits (130 x 80% see below) 104
Gain on investments – Pacemaker (see below) 5
Video Tech’s post-acquisition profits (w (iii)) 24
URP in Inventories (56 x 40/140) (16)
247
Shield’s retained earnings:
Post-acquisition (260 – 120) 140
Additional depreciation/Amortisation (2 + 5) (7)
Loss on available-for-sale investments (40 – 37) (3)
Adjusted post-acquisition profits 130

Gain on the value of Pacemaker’s available-for-sale investments:

Carrying amount at 31 March 2008 (345 – 210 cash – 58 loan note) 77
Carrying amount at 31 March 2009 82
Gain to retained earnings (or other components of equity) 5
v.

Non-controlling interest
Fair value on acquisition (from question) 65
Share of adjusted post-acquisition profit (130 x 20% (w (iv))) 26
91

Question No 2:-

The following trial balance relates to Coca Cola at 30 September 2008:

Rs’000 Rs’000
Leasehold property – at valuation 1 October 2007 (note (i)) 50,000
Plant and equipment – at cost (note (i)) 76,600
Plant and equipment – accumulated depreciation at 1 October 24,600
2007
Capitalised development expenditure – at 1 October 2007 (note 20,000
(ii))
Development expenditure – accumulated amortization at 1 6,000
October 2007
Closing inventory at 30 September 2008 20,000
Trade receivables 43,100
Bank 1,300
Trade payables and provisions (note (iii)) 23,800
Revenue (note (i)) 300,000
Cost of sales 204,000
Distribution costs 14,500
Administrative expenses (note (iii)) 22,200
Preference dividend paid 800
Interest on bank borrowings 200
Equity dividend paid 6,000
Research and development costs (note (ii)) 8,600
Equity shares of 25 Paisa each 50,000
8% redeemable preference shares of Rs1 each (note (iv)) 20,000
Retained earnings at 1 October 2007 24,500
Deferred tax (note (v)) 5,800
Leasehold property revaluation reserve 10,000
466,000 466,000
The following notes are relevant:

i. Non-current assets – tangible:

The leasehold property had a remaining life of 20 years at 1 October 2007. The
company’s policy is to revalueits property at each year end and at 30 September
2008 it was valued at Rs43 million. Ignore deferred tax onthe revaluation.

On 1 October 2007 an item of plant was disposed of for Rs2.5 million cash. The
proceeds have been treated assales revenue by Coca Cola. The plant is still
included in the above trial balance figures at its cost of Rs8 million
andaccumulated depreciation of Rs4 million (to the date of disposal).

All plant is depreciated at 20% per annum using the reducing balance method.

Depreciation and amortization of all non-current assets is charged to cost of

sales.

ii. Non-current assets – intangible:

In addition to the capitalised development expenditure (of Rs20 million), further

research and development costswere incurred on a new project which
commenced on 1 October 2007. The research stage of the new projectlasted until
 31 December 2007 and incurred Rs1.4 million of costs. From that date the project
incurreddevelopment costs of Rs800, 000 per month. On 1 April 2008 the
directors became confident that the projectwould be successful and yield a profit
well in excess of its costs. The project is still in development at30 September 2008.

Capitalised development expenditure is amortised at 20% per annum using the

straight-line method. Allexpensed research and development is charged to cost
of sales.

iii. Coca Cola is being sued by a customer for Rs2 million for breach of contract over
a cancelled order. Coca Cola has obtained legal opinion that there is a 20%
chance that Coca Cola will lose the case. Accordingly Coca Cola has provided
Rs400, 000 (Rs2 million x 20%) included in administrative expenses in respect of
the claim. The unrecoverable legal costs of defending the action are estimated at
Rs100, 000. These have not been provided for as the legal action will not go to
court until next year.
iv. The preference shares were issued on 1 April 2008 at par. They are redeemable at
a large premium which gives them an effective finance cost of 12% per annum.
v. The directors have estimated the provision for income tax for the year ended 30
September 2008 at Rs11.4 million. The required deferred tax provision at 30
September 2008 is Rs6 million.

Required:

a) Prepare the statement of comprehensive income for the year ended 30

September 2008.
b) Prepare the statement of changes in equity for the year ended 30 September
2008.
c) Prepare the statement of financial position as at 30 September 2008.

Note: notes to the financial statements are not required.

Answer No 2:-

a) Coca Cola – Statement of comprehensive income for the year ended 30

September 2008
Rs’000
Revenue (300,000 – 2,500) 297,500
Cost of sales (w (i)) (225,400)
Gross profit 72,100
Distribution costs (14,500)
Administrative expenses (22,200 – 400 + 100 see note below) (21,900)
Finance costs (200 + 1,200 (w (ii))) (1,400)
Profit before tax 34,300
(Income tax expense (11,400 + (6,000 – 5,800 deferred tax)) (11,600)
 Profit for the year 22,700
Other comprehensive income
Loss on leasehold property revaluation (w (iii)) (4,500)
Total comprehensive income for the year 18,200

Note: as it is considered that the outcome of the legal action against Coca Cola is
unlikely to succeed (only a 20% chance) it isinappropriate to provide for any
damages. The potential damages are an example of a contingent liability which
should bedisclosed (at Rs2 million) as a note to the financial statements. The
unrecoverable legal costs are a liability (the start of thelegal action is a past event)
and should be provided for in full.
b) Coca Cola – Statement of changes in equity for the year ended 30 September
2008
Equity Revaluation Retained Total
shares reserve earnings equity
Rs’000 Rs’000 Rs’000 Rs’000
Balances at 1 October 2007 50,000 10,000 24,500 84,500
Dividend (6,000) (6,000)
Comprehensive income (4,500) 22,700 18,200
Balances at 30 September 2008 50,000 5,500 41,200 96,700

c) Coca Cola – Statement of financial position as at 30 September 2008

Assets Rs’000 Rs’000
Non-current assets (w (iii))
Property, plant and equipment (43,000 + 38,400) 81,400
Development costs 14,800
96,200
Current assets
Inventory 20,000
Trade receivables 43,100 63,100
Total assets 159,300
Equity and liabilities:
Equity (from (b))
Equity shares of 25 Paisa each 50,000
Revaluation reserve 5,500
Retained earnings 41,200 46,700
96,700
Non-current liabilities
Deferred tax 6,000
8% redeemable preference shares (20,000 + 400 (w (ii))) 20,400 26,400
Current liabilities
Trade payables (23,800 – 400 + 100 – re legal action) 23,500
Bank overdraft 1,300
Current tax payable 11,400 36,200
Total equity and liabilities 159,300
Workings (figures in brackets in Rs’000)
i.
Cost of sales: Rs’000
Per trial balance 204,000
Depreciation (w (iii)) – leasehold property 2,500
– plant and equipment 9,600
Loss on disposal of plant (4,000 – 2,500) 1,500
Amortisation of development costs (w (iii)) 4,000
Research and development expensed (1,400 + 2,400 (w (iii))) 3,800
225,400
ii. The finance cost of Rs1.2 million for the preference shares is based on the
effective rate of 12% applied to Rs20 million issue proceeds of the shares
for the six months they have been in issue (20m x 12% x 6/12). The
dividend paid of Rs800, 000 is based on the nominal rate of 8%. The
additional Rs400, 000 (accrual) is added to the carrying amount of the
preference shares in the statement of financial position. As these shares
are redeemable they are treated as debt andtheir dividend is treated as a
finance cost.

iii. Non-current assets:

Leasehold property
Valuation at 1 October 2007 50,000
Depreciation for year (20 year life) (2,500)
Carrying amount at date of revaluation 47,500
Valuation at 30 September 2008 (43,000)
Revaluation deficit 4,500
Rs’000
Plant and equipment per trial balance (76,600 – 24,600) 52,000
Disposal (8,000 – 4,000) (4,000)
48,000
Depreciation for year (20%) (9,600)
Carrying amount at 30 September 2008 38,400
Capitalised/deferred development costs
Carrying amount at 1 October 2007 (20,000 – 6,000) 14,000
Amortised for year (20,000 x 20%) (4,000)
Capitalised during year (800 x 6 months) 4,800
Carrying amount at 30 September 2008 14,800

Note: development costs can only be treated as an asset from the point
where they meet the recognition criteria inIAS 38 Intangible assets. Thus
development costs from 1 April to 30 September 2008 of Rs4.8 million
(800 x 6 months)can be capitalised. These will not be amortised as the
project is still in development. The research costs of Rs1.4 millionplus
 three months’ development costs of Rs2.4 million (800 x 3 months) (i.e.
those incurred before 1 April 2008) aretreated as an expense.

Question No 3:-

The dividend paid in November 2010 was Rs5.6 million. This is based on 112
million shares in issue (56,000 x 2 – the shares are 50 Paisa each) times 5 Paisa.

Income statements for the year ended 31 March

2011 2010
Rs’000 Rs’000
Revenue 25,500 17,250
Cost of sales (14,800) (10,350)
Gross profit 10,700 6,900
Distribution costs (2,700) (1,850)
Administrative expenses (2,100) (1,450)
Finance costs (650) (100)
Profit before taxation 5,250 3,500
Income tax expense (2,250) (1,000)
Profit for the year 3,000 2,500
Statements of financial position as at 31 March

2011 2010
Rs’000 Rs’000 Rs’000 Rs’000
Non-current assets
Property, plant and equipment 9,500 5,400
Intangibles 6,200 Nil
15,700 5,400
Current assets
Inventory 3,600 1,800
Trade receivables 2,400 1,400
Bank Nil 4,000
Non-current assets held for sale 2,000 8,000 Nil 7,200
Total assets 23,700 12,600
Equity and liabilities
Equity
Equity shares of Rs1 each 5,000 5,000
Retained earnings 4,500 2,250
9,500 7,250
Non-current liabilities
5% loan notes 2,000 2,000
8% loan notes 7,000 Nil
Current liabilities
Bank overdraft 200 Nil
Trade payables 2,800 2,150
Current tax payable 2,200 5,200 1,200 3,350
Total equity and liabilities 23,700 12,600
Notes

i. There were no disposals of non-current assets during the period; however

Bengal does have some non-current assets classified as ‘held for sale’ at 31
March 2011.
ii. Depreciation of property, plant and equipment for the year ended 31
March 2011 was Rs640, 000.

A disappointed shareholder has observed that although revenue during the year
has increased by 48% (8,250/17,250 x 100), profit for the year has only increased
by 20% (500/2,500 x 100).

Required:

a) Prepare a statement of cash flows for Bengal for the year ended 31
March 2011, in accordance with IAS 7 Statement of cash flows, using the
indirect method.
b) Using the information in the question and your answer to (a) above,
comment on the performance (including addressing the shareholder’s
observation) and financial position of Bengal for the year ended 31
March 2011.

Answer No 3:-
a) Bengal – Statement of cash flows for the year ended 31 March 2011:
(Note: figures in brackets are in Rs’000)
Rs’000 Rs’000
Cash flows from operating activities:
Profit before tax 5,250
Adjustments for:
depreciation of non-current assets 640
finance costs 650
Increase in inventories (3,600 – 1,800) (1,800)
Increase in receivables (2,400 – 1,400) (1,000)
Increase in payables (2,800 – 2,150) 650
Cash generated from operations 4,390
Finance costs paid (650)
Income tax paid (w (i)) (1,250)
Net cash from operating activities 2,490
Cash flows from investing activities:
Purchase of property, plant and equipment (w (ii)) (6,740)
Purchase of intangibles (6,200)
Net cash used in investing activities (12,940)
Cash flows from financing activities:
Issue of 8% loan note 7,000
Equity dividends paid (w (iii)) (750)
Net cash from financing activities 6,250
Net decrease in cash and cash equivalents (4,200)
Cash and cash equivalents at beginning of period 4,000
Cash and cash equivalents at end of period (200)

Workings
i.

Income tax paid: Rs’000

Provision b/f (1,200)
Income statement tax charge (2,250)
Provision c/f – current 2,200
Balance – cash paid (1,250)

ii.

Property, plant and equipment: Rs’000

Balance b/f 5,400
Depreciation (640)
Balance c/f – current (9,500)
– held for sale (2,000)
Balance – cash purchases 6,740
iii.

Equity dividend
 Retained earnings b/f 2,250
Profit for period 3,000
Retained earnings c/f (4,500)
Balance – dividend paid 750

b) Note: references to 2011 and 2010 refer to the periods ending 31 March
2011 and 2010 respectively.
It is understandable that the shareholder’s observations would cause
concern. A large increase in sales revenue has not ledto a proportionate
increase in profit. To assess why this has happened requires consideration
of several factors that couldpotentially explain the results. Perhaps the
most obvious would be that the company has increased its sales by
discountingprices (cutting profit margins).Interpreting the ratios in the
appendix rules out this possible explanation as the gross profitmargin has
in fact increased in 2011 (up from 40% to 42%). Another potential cause of
the disappointing profit could beoverheads (distribution costs and
administrative expenses) getting out of control, perhaps due to higher
advertising costs ormore generous incentives to sales staff. Again, when
these expenses are expressed as a percentage of sales, this does notexplain
the disparity in profit as the ratio has remained at approximately 19%.
What is evident is that there has been a verylarge increase in finance costs
which is illustrated by the interest cover deteriorating from 36 times to
only 9 times. The other‘culprit’ is the taxation expense: expressed as a
percentage of pre-tax accounting profit, the effective rate of tax has gone
from28.6% in 2010 to 42.9% in 2011. There are a number of factors that can
affect a period’s effective tax rate (including underorover-provisions from
the previous year), but judging from the figures involved, it would seem
likely that either there was amaterial adjustment from an under-provision
of tax in 2010 or there has been a considerable increase in the rate levied
bythe taxation authority.
As an illustration of the effect, if the same effective tax rate in 2010 had
applied in 2011, the after-tax profit would have been Rs3, 749,000 (5,250 x
(100% – 28.6%) rounded) and, using this figure, the percentage increase in
profit would be 50%
((3,749 – 2,500)/2,500 x 100) which is slightly higher than the percentage
increase in revenue. Thus an increase in thetax rate and increases in
finance costs due to much higher borrowings more than account for the
disappointing profitcommented upon by the concerned shareholder.
The other significant observation in comparing 2011 with 2010 is that the
company has almost certainty acquired anotherbusiness. The increased
expenditure on property, plant and equipment of Rs6, 740,000 and the
newly acquired intangibles(probably goodwill) of Rs6.2 million are not
likely to be attributable to organic or internal growth. Indeed the decrease
in thebank balance of Rs4.2 million and the issue of Rs7 million loan notes
closely match the increase in non-current assets. Thisimplies that the
acquisition has been financed by cash resources (which the company looks
to have been building up) andissuing debt (no equity was issued). This in
turn explains the dramatic increase in the gearing ratio (and the
consequent fallin interest cover) and the fall in the current ratio (due to the
use of cash resources for the business purchase). Although thecurrent
ratio at 1.5:1 is on the low side of acceptability, it does include Rs2 million
of non-current assets held for sale. A bettercomparison with 2010 is the
current ratio at 1.2:1 which excludes the non-current assets held for sale. It
may be that theseassets were part of the acquisition of the new business
and are ‘surplus to requirements’, hence they have been madeavailable for
sale. They are likely to be valued at their ‘fair value less cost to sell’ and
the prospect of their sale should behighly probable (normally within one
year). That said, if the assets are not sold in the near future, it would call
into questionthe acceptability of the company’s current ratio which may
cause short-term liquidity problems.
The overall performance of Bengal has deteriorated (as measured by its
ROCE) from 38.9% to 31.9%. This is mainly due toa lower rate of net asset
turnover (down from 1.9 to 1.4 times), however when the turnover of
property, plant and equipmentis considered (down from 3.2 to 2.7 times)
the asset utilization position is not as bad as it first looks, in effect it is
thepresence of the acquired intangibles that is mostly responsible for the
fall.
Further, it may be that the new business was acquired part way through
the year and thus the returns from this element maybe greater next year
when a full period’s profits will be reported. It may also be that the
integration of the new businessrequires time (and expense) before it
delivers its full potential.
 In summary, although reported performance has deteriorated, it may be
that future results will benefit from the current year’sinvestment and
show considerable improvement. Perhaps some equity should have been
issued to lower the company’sgearing (and finance costs) and if the
dividend of Rs750, 000 had been suspended for a year there would be a
better liquidposition.

Question No 4:-

The International Accounting Standards Board (IASB) has begun a joint project
to revisit its conceptual framework for financial accounting and reporting. The
goals of the project are to build on the existing frameworks and converge them
into a common framework.

Required:

a) Discuss why there is a need to develop an agreed international

conceptual framework and the extent to which an agreed international
conceptual framework can be used to resolve practical accounting
issues.
b) Discuss the key issues which will need to be addressed in determining
the basic components of an internationally agreed conceptual
framework.

Appropriateness and quality of discussion.

Answer No 4:-

a) The IASB wish their standards to be ‘principles-based’ and in order for

this to be the case, the standards must be based on fundamental concepts.
These concepts need to constitute a framework which is sound,
comprehensive and internally consistent. Without agreement on a
framework, standard setting is based upon the personal conceptual
frameworks of the individual standard setters which may change as the
membership of the body changes and results in standards that are not
consistent with each other. Such a framework is designed not only to
assist standard setters, but also preparers of financial statements, auditors
and users.
A common goal of the IASB is to converge their standards with national
standard setters. The IASB will encounter difficultiesconverging their
standards if decisions are based on different frameworks. The IASB has
been pursuing a number of projectsthat are aimed at achieving short term
convergence on certain issues with national standard setters as well as
major projectswith them. Convergence will be difficult if there is no
consistency in the underlying framework being used.
Frameworks differ in their authoritative status. The IASB’s Framework
requires management to expressly consider theFramework if no standard
or interpretation specifically applies or deals with a similar and related
issue. However, certainframeworks have a lower standing. For example,
entities are not required to consider the concepts embodied in
certainnational frameworks in preparing financial statements. Thus the
development of an agreed framework would eliminatedifferences in the
authoritative standing of conceptual frameworks and lead to greater
consistency in financial statementsinternationally.
The existing concepts within most frameworks are quite similar.
However, these concepts need revising to reflect changes inmarkets,
business practices and the economic environment since the concepts were
developed. The existing frameworks needdeveloping to reflect these
changes and to fill gaps in the frameworks. For example, the IASB’s
Framework does not containa definition of the reporting entity. An agreed
international framework could deal with this problem, especially if
priority wasgiven to the issues likely to give short-term standard setting
benefits.
Many standard setting bodies attempted initially to resolve accounting
and reporting problems by developing accountingstandards without an
accepted theoretical frame of reference. The result has been inconsistency
in the development ofstandards both nationally and internationally. The
frameworks were developed when several of their current standards
werein existence. In the absence of an agreed conceptual framework the
same theoretical issues are revisited on several occasionsby standard
setters. The result is inconsistencies and incompatible concepts. Examples
of this are substance over form andmatching versus prudence. Some
standard setters such as the IASB permit two methods of accounting for
the same set ofcircumstances. An example is the accounting for joint
ventures where the equity method and proportionate consolidation
areallowed.
Additionally there have been differences in the way that standard setters
have practically used the principles in the framework.Some national
standard setters have produced a large number of highly detailed
accounting rules with less emphasis ongeneral principles. A robust
framework might reduce the need for detailed rules although some
companies operate in adifferent legal and statutory context than other
entities. It is important that a framework must result in standards that
accountappropriately for actual business practice.
An agreed framework will not solve all accounting issues, nor will it
obviate the need for judgement to be exercised in resolvingaccounting
issues. It can provide a framework within which those judgements can be
made.
A framework provides standard setters with both a foundation for setting
standards, and concepts to use as tools for resolvingaccounting and
reporting issues. A framework provides a basic reasoning on which to
consider the merits of alternatives. Itdoes not provide all the answers, but
narrows the range of alternatives to be considered by eliminating some
that areinconsistent with it. It, thereby, contributes to greater efficiency in
the standard setting process by avoiding the necessity ofhaving to
redebate fundamental issues and facilitates any debate about specific
technical issues. A framework should alsoreduce political pressures in
making accounting judgements. The use of a framework reduces the
influence of personal biasesin accounting decisions.
However, concepts statements are by their nature very general and
theoretical in their wording, which leads to alternativeconclusions being
drawn. Whilst individual standards should be consistent with the
Framework, in the absence of a specificstandard, it does not follow that
concepts will provide practical solutions. IAS8 ‘Accounting Policies,
Changes in AccountingEstimates and Errors’ sets out a hierarchy of
authoritative guidance that should be considered in the absence of a
standard.In this case, management can use its judgement in developing
and applying an accounting policy, albeit by considering theIASB
framework, but can also use accounting standards issued by other bodies.
 Thus an international framework may nottotally provide solutions to
practical accounting problems.
b) There are several issues which have to be addressed if an international
conceptual framework is to be successfully developed.

These are:

i. Objectives
Agreement will be required as to whether financial statements are
to be produced for shareholders or a wide range ofusers and
whether decision usefulness is the key criteria or stewardship.
Additionally there is the question of whetherthe objective is to
provide information in making credit and investment decisions.

ii. Qualitative Characteristics

The qualities to be sought in making decisions about financial
reporting need to be determined. The decision usefulnessof
financial reports is determined by these characteristics. There are
issues concerning the trade-offs between relevanceand reliability.
An example of this concerns the use of fair values and historical
costs. It has been argued that historicalcosts are more reliable
although not as relevant as fair values. Additionally there is a
conflict between neutrality and thetraditions of prudence or
conservatism. These characteristics are constrained by materiality
and benefits that justifycosts.

iii. Definitions of the elements of financial statements

The principles behind the definition of the elements need
agreement. There are issues concerning whether ‘control’should be
included in the definition of an asset or become part of the
recognition criteria. Also the definition of ‘control’is an issue
particularly with financial instruments. For example, does the
holder of a call option ‘control’ the underlyingasset? Some of the
IASB’s standards contravene its own conceptual framework. IFRS3
requires the capitalisation ofgoodwill as an asset despite the fact
that it can be argued that goodwill does not meet the definition of
an asset in theFramework. IAS12 requires the recognition of
deferred tax liabilities that do not meet the liability definition.
Similarlyequity and liabilities need to be capable of being clearly
distinguished. Certain financial instruments could either
beliabilities or equity. For example obligations settled in shares.
iv. Recognition and De-recognition
The principles of recognition and de-recognition of assets and
liabilities need reviewing. Most frameworks haverecognition
criteria, but there are issues over the timing of recognition. For
example, should an asset be recognised whena value can be placed
on it or when a cost has been incurred? If an asset or liability does
not meet recognition criteriawhen acquired or incurred, what
subsequent event causes the asset or liability to be recognised?
Most frameworks donot discuss de-recognition. (The IASB’s
Framework does not discuss the issue.) It can be argued that an
item should bede-recognised when it does not meet the recognition
criteria, but financial instruments standards (IAS39) require
otherfactors to occur before financial assets can be de-recognised.
Different attributes should be considered such as legalownership,
control, risks or rewards.

v. Measurement
More detailed discussion of the use of measurement concepts, such
as historical cost, fair value, current cost, etc arerequired and also
more guidance on measurement techniques. Measurement concepts
should address initialmeasurement and subsequent measurement
in the form of revaluations, impairment and depreciation which in
turngives rise to issues about classification of gains or losses in
income or in equity.

vi. Reporting entity

Issues have arisen over what sorts of entities should issue financial
statements, and which entities should be includedin consolidated
financial statements. A question arises as to whether the legal entity
or the economic unit should be thereporting unit. Complex
business arrangements raise issues over what entities should be
consolidated and the basisupon which entities are consolidated. For
example, should the basis of consolidation be ‘control’ and what
does ‘control’mean?

vii. Presentation and disclosure

Financial reporting should provide information that enables users
to assess the amounts, timing and uncertainty of theentity’s future
cash flows, its assets, liabilities and equity. It should provide
management explanations and the limitationsof the information in
the reports. Discussions as to the boundaries of presentation and
disclosure are required.
Question No 5:-

Whilst acknowledging the importance of high quality corporate reporting, the

recommendations to improve it aresometimes questioned on the basis that the
marketplace for capital can determine the nature and quality of
corporatereporting. It could be argued that additional accounting and disclosure
standards would only distort a marketmechanism that already works well and
would add costs to the reporting mechanism, with no apparent benefit. Itcould
be said that accounting standards create costly, inefficient, and unnecessary
regulation. It could be argued thatincreased disclosure reduces risks and offers a
degree of protection to users. However, increased disclosure has severalcosts to
the preparer of financial statements.

Required:

a) Explain why accounting standards are needed to help the market

mechanism work effectively for the benefit of preparers and users of
corporate reports.
b) Discuss the relative costs to the preparer and benefits to the users of
financial statements of increased disclosure of information in financial
statements.

Quality of discussion and reasoning.

Answer No 5:-

a) It could be argued that the marketplace already offers powerful incentives

for high-quality reporting as it rewards such by easing or restricting
access to capital or raising or lowering the cost of borrowing capital
depending on the quality of the entity’s reports. However, accounting
standards play an important role in helping the market mechanism work
effectively. Accounting standards are needed because they:
- Promote a common understanding of the nature of corporate
performance and this facilitates any negotiations between users and
companies about the content of financial statements. For example,
many loan agreements specify that a company provide the lender with
financial statements prepared in accordance with generally accepted
accounting principles or International Financial Reporting Standards.
Both the company and the lender understand the terms and are
 comfortable that statements prepared according to those standards
will meet certain information needs. Without standards, the statements
would be less useful to the lender, and the company and the lender
would have to agree tocreate some form of acceptable standards which
would be inefficient and less effective.
- Assist neutral and unbiased reporting. Companies may wish to
portray their past performance and future prospects in the most
favourable light. Users are aware of this potential bias and are sceptical
about the information they receive.Standards build credibility and
confidence in the capital marketplace to the benefit of both users and
companies.
- Improve the comparability of information across companies and
national boundaries. Without standards, there would be little basis to
compare one company with others across national boundaries which is
a key feature of relevantinformation.
- Create credibility in financial statements. Auditors verify that
information is reported in accordance with standards andthis creates
public confidence in financial statements
- Facilitate consistency of information by producing data in accordance
with an agreed conceptual framework. A consistent approach to the
development and presentation of information assists users in accessing
information in an efficientmanner and facilitates decision-making.

b) Increased information disclosure benefits users by reducing the likelihood

that they will misallocate their capital. This is obviously a direct benefit to
individual users of corporate reports. The disclosure reduces the risk of
misallocation of capitalby enabling users to improve their assessments of a
company’s prospects. This creates three important results.
i. Users use information disclosed to increase their investment
returns and by definition support the most profitable companies
which are likely to be those that contribute most to economic
growth. Thus, an important benefit of information disclosure is that
it improves the effectiveness of the investment process.
ii. The second result lies in the effect on the liquidity of the capital
markets. A more liquid market assists the effective allocation of
capital by allowing users to reallocate their capital quickly. The
degree of information asymmetry between the buyer and seller and
 the degree of uncertainty of the buyer and the seller will affect the
liquidity of the market as lower asymmetry and less uncertainty
will increase the number of transactions and make the market more
liquid.
Disclosure will affect uncertainty and information asymmetry.
iii. Information disclosure helps users understand the risk of a
prospective investment. Without any information, the user has no
way of assessing a company’s prospects. Information disclosure
helps investors predict a company’s prospects. Getting a better
understanding of the true risk could lower the price of capital for
the company. It is difficult to prove however that the average cost
of capital is lowered by information disclosure, even though it is
logically and practically impossible to assess a company’s risk
without relevant information. Lower capital costs promote
investment, which canstimulate productivity and economic
growth.

However although increased information can benefit users, there are

problems of understandability and information overload.

Information disclosure provides a degree of protection to users. The

benefit is fairness to users and is part of corporateaccountability to society
as a whole.

The main costs to the preparer of financial statements are as follows:

i. the cost of developing and disseminating information,

ii. the cost of possible litigation attributable to information disclosure,
iii. the cost of competitive disadvantage attributable to disclosure.

The costs of developing and disseminating the information include those

of gathering, creating and auditing the information.

Additional costs to the preparers include training costs, changes to

systems (for example on moving to IFRS), and the morecomplex and the
greater the information provided, the more it will cost the company.

Although litigation costs are known to arise from information disclosure,

it does not follow that all information disclosure leadsto litigation costs.
Cases can arise from insufficient disclosure and misleading disclosure.
Only the latter is normally promptedby the presentation of information
disclosure. Fuller disclosure could lead to lower costs of litigation as the
stock market wouldhave more realistic expectations of the company’s
prospects and the discrepancy between the valuation implicit in the
marketprice and the valuation based on a company’s financial statements
would be lower. However, litigation costs do notnecessarily increase with
the extent of the disclosure. Increased disclosure could reduce litigation
costs.

Disclosure could weaken a company’s ability to generate future cash

flows by aiding its competitors. The effect of disclosureon competitiveness
involves benefits as well as costs. Competitive disadvantage could be
created if disclosure is made relatingto strategies, plans, (for example,
planned product development, new market targeting) or information
about operations (forexample, production-cost figures). There is a
significant difference between the purpose of disclosure to users
andcompetitors. The purpose of disclosure to users is to help them to
estimate the amount, timing, and certainty of future cashflows.
Competitors are not trying to predict a company’s future cash flows, and
information of use in that context is notnecessarily of use in obtaining
competitive advantage. Overlap between information designed to meet
users’ needs andinformation designed to further the purposes of a
competitor is often coincidental. Every company that could suffer
competitivedisadvantage from disclosure could gain competitive
advantage from comparable disclosure by competitors. Published
figuresare often aggregated with little use to competitors.

Companies bargain with suppliers and with customers, and information

disclosure could give those parties an advantage innegotiations. In such
cases, the advantage would be a cost for the disclosing entity. However,
the cost would be offsetwhenever information disclosure was presented
by both parties, each would receive an advantage and a disadvantage.

There are other criteria to consider such as whether the information to be

disclosed is about the company. This is both abenefit and a cost criterion.
Users of corporate reports need company-specific data, and it is typically
more costly to obtainand present information about matters external to
the company. Additionally, consideration must be given as to whether
thecompany is the best source for the information. It could be inefficient
for a company to obtain or develop data that other, moreexpert parties
could develop and present or do develop at present.

There are many benefits to information disclosure and users have unmet
information needs. It cannot be known with anycertainty what the
optimal disclosure level is for companies. Some companies through
voluntary disclosure may haveachieved their optimal level. There are no
quantitative measures of how levels of disclosure stand with respect to
optimallevels. Standard setters have to make such estimates as best they
can, guide by prudence, and by what evidence of benefitsand costs they
can obtain.