1

MODULE 1
THE FINANCIAL
REPORTING
ENVIRONMENT
Describe the regulatory environment for financial reporting in Australia and the reasons LO1.1
for accounting and reporting requirements
Discuss the main types of business entity and explain the reasons for selecting each LO1.2
structure
Identify different types of accounting regulation, including laws, Generally Accepted LO1.3
Accounting Principles and International Financial Reporting Standards
Explain how the requirements from users, together with social and environmental LO1.4
developments, impact the underlying principles and requirements of financial reporting
and the desire to establish a single set of international accounting standards
Describe the role of the International Accounting Standards Board in developing a LO1.5
regulatory framework and explain how new policies and standards are established
Identify the purpose of a conceptual framework and the key characteristics in the LO1.6
Generally Accepted Accounting Principles (GAAP) and apply the knowledge to define
and recognise the different elements of the financial systems
Describe and demonstrate the role of accounting standards and accounting policies in LO1.7
fairly presenting the financial performance and financial position of an entity

Topic list

1 The purpose of accounting

2 Nature, principles and scope of financial reporting
3 The reporting entity
4 Users' and shareholders' needs
5 The need for a regulatory framework
6 The IFRS Foundation and the IASB
7 Conceptual framework and GAAP
8 The IASB's Conceptual Framework
9 The objective of general purpose financial reporting
10 Accounting regulation
2 | THE FINANCIAL REPORTING ENVIRONMENT

Topic list

11 Future developments
12 Accounting policies
13 IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
14 The role of accounting standards
15 Accounting standards and choice
16 Accounting concepts
17 Qualitative characteristics of financial information
18 International Financial Reporting Standards
19 Developments in international harmonisation
20 The elements of financial statements
21 Recognition of the elements of financial statements
22 Applying the recognition criteria
23 The main financial statements
 FINANCIAL ACCOUNTING AND REPORTING | 3

MODULE OUTLINE

This module introduces some basic ideas about the need for financial information and the users of
financial information. It also covers the definition of financial reporting.
We then move on to look at the different sources of accounting regulation. Accounting is regulated by
local statute (such as company law), by stock exchange requirements and by accounting standards.
We will focus in particular on the activities of the International Accounting Standards Board (IASB)
which is responsible for setting International Financial Reporting Standards (IFRS).
We will discuss the importance of IFRS in the global regulation of accounting and the process the
IASB undertakes in issuing a new accounting standard.
We move on to look at the IASB's Conceptual Framework for Financial Reporting which represents the
upon which all IFRS are based.
We also consider accounting policies: the specific principles and conventions that an entity adopts in
preparing and presenting financial statements. IAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors explains how an entity should select and apply accounting policies.
We examine the role and purpose of accounting standards in the regulation of financial reporting. We
will look at this in the context of accounting policies and achieving the aim of preparing useful
financial information.
We will also review some of the key accounting concepts that have to be considered when preparing
financial statements and discuss the process of harmonisation of accounting standards on a global
basis.
We will examine the main elements of financial statements: assets, liabilities, equity, income and
expenses. Finally, we will look at the financial statements where these items are recognised and
examine the recognition criteria for each of the elements of the financial statements.
The module content is summarised in the diagrams below.
4 | THE FINANCIAL REPORTING ENVIRONMENT

The financial reporting environment

Financial reporting involves Need for regulation:

Accounting: process of producing financial statements
recording, analysing and GAAP is a combination of:
for users
summarising transactions • company law
of a business and • accounting standards
communicating that • stock exchange rules
information to decision • IFRSs
makers Users have different needs:
• management
• shareholders
• suppliers Regulation varies
• customers amongst countries
Reporting entity: depending on local context
• lenders
entity whose general and level of development
purpose financial • authorities
of the nation
statements are relied • employees
upon by users of • financial analysts and
accounts advisers
• public Benefits of regulation:
• Information prepared
consistently
• Companies disclose
A regulatory framework and more information than
accounting standards help make they would if there was
financial statements more useful no regulation
to users

IASB issues standards

IASB objectives:
• To develop high quality,
understandable and enforceable
global accounting standards
• To bring about convergence of
national standards and IFRS
 FINANCIAL ACCOUNTING AND REPORTING | 5

The Conceptual Framework and

accounting policies

Conceptual framework and The IASB's Conceptual Framework for The use of judgment in
GAAP Conceptual framework Financial Reporting is the international accounting decisions:
is a set of theoretical principles conceptual framework. Accounting standards provide
that form a frame of reference Its purpose is to: guidance on dealing with
for financial reporting
assist with the development of transactions
future accounting standards If no standard exists, the
promote harmonisation accountant must use
assist national standard-setters judgement
Benefits of framework: Conceptual Framework is a
assist auditors, preparers and users
Used as a basis for of financial statements useful reference point in
development of accounting these situations
standards
Financial reporting based on
standardised principles
Preparers apply the spirit and
reasoning behind standards; Objective of general purpose Accounting policies:
therefore harder to avoid financial reporting: Principles, bases, rules,
compliance Provide useful information to conventions and practices
existing and potential investors, used in preparing financial
lenders and other creditors statements
Provide information that is
relevant and faithfully
represents the underlying
transactions

IAS 8 Accounting Policies, Changes

in Accounting Estimates and Errors

Accounting standards and concepts

Role of accounting standards: Accounting concepts: International harmonisation

Set out accounting rules Going concern (underlying Aim to have one set of global
companies must follow assumption) accounting standards
Applying accounting standards Accruals Number of barriers, but many
should give a fair presentation Substance over form advantages
EU adopted IFRS from 2005
IASB and US FASB have
carried out important joint
Accounting standards and choice: projects to harmonise
Standards reduce variations in Fundamental qualitative accounting standards
methods of accounting characteristics of financial
information: relevance and
But may be faithful representation
inflexible/inappropriate in
some circumstances

Enhancing qualitative
characteristics of financial
information: comparability;
verifiability; timeliness; and
understandability
6 | THE FINANCIAL REPORTING ENVIRONMENT

Elements of financial
statements and their
recognition criteria

Elements of financial Recognition criteria The main elements of financial

statements • The Conceptual Framework states reports
The Conceptual Framework that an element of the financial • The statement of financial
defines: statements is recognised if it: position includes:
• assets – meets the definition of an – assets
• liabilities element; – liabilities
• equity – is probable that any future – equity
• income economic benefit associated • The statement of profit or
• expenses with the item will flow to or loss and other
from the entity; and comprehensive income
– the item has a cost or value includes:
that can be measured with – income
reliability – expenses
 FINANCIAL ACCOUNTING AND REPORTING | 7

BEFORE YOU BEGIN

If you have studied these topics before, you may wonder whether you need to study this module in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in
the area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the module to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the module you can find the information, and you
will also find a commentary at the back of the Study Guide.
1 Identify three differences between financial and management accounts.
2 What is the purpose of financial reporting?
3 What is a reporting entity?
4 Who are the main user groups of financial statements, and why are they
interested in financial information?
5 What is GAAP?
6 Which of the following are advantages of accounting regulation?
I. increased public confidence in financial statements
II. enhanced comparability between financial statements
III. the development of rules which are applicable to all entities
IV. the disclosure of more useful information than if there were no regulations

A I and IV only
B I, II and IV only
C II, III and IV only
D I, II, III and IV
7 What is the IASB and what are its objectives?
8 What is the IFRS Advisory Council and what is its purpose?
9 What is the IFRS Interpretations Committee and what is its purpose?
10 What is a conceptual framework?
11 What are the problems associated with having a conceptual framework?
12 Which of the following are objectives of the IASB's Conceptual Framework?
I. to promote consistency between IFRS
II. to assist in the development of new IFRS
III. to assist auditors in forming their opinion
IV. to assist national standard-setters in setting national standards

A I and II only
B III and IV only
C I, II and IV only
D I, II, III and IV
13 What is the objective of general purpose financial reporting according to the
IASB's Conceptual Framework?
14 What are accounting policies?
15 How is a change in accounting policy accounted for?
16 How is a change in accounting estimate accounted for?
17 What is the underlying assumption in preparing financial statements according
to the Conceptual Framework?
8 | THE FINANCIAL REPORTING ENVIRONMENT

18 Explain the concept of 'substance over form' and provide an example of

its application.
19 What are the two fundamental qualitative characteristics and the four
enhancing qualitative characteristics of financial statements identified by
the Conceptual Framework?
20 What makes financial information relevant?
21 Identify three barriers to the global harmonisation of accounting standards.
22 Define an asset.
23 Define a liability.
24 Define equity.
25 What criteria must be met in order for an item to be recognised in the financial
statements?
26 Which of the following statements is/are correct?
I. All assets and liabilities must always be presented in order of liquidity.
II. A liability is always classified as non-current where the amount due is to be settled in more than
12 months.

A I only
B II only
C both I and II
D neither I nor II
 FINANCIAL ACCOUNTING AND REPORTING | 9

1 THE PURPOSE OF ACCOUNTING

Section overview
 Accounting is the process of recording, analysing and summarising transactions of an entity
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.
 Non-commercial undertakings 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

is the process of recording, analysing and summarising transactions of a business and

communicating that information to decision makers.

Renaissance scholar wrote the first printed explanation of double-entry bookkeeping in

1494. Double-entry bookkeeping involves entering every transaction as a in one account and a
corresponding 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

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 information.
 10 | THE FINANCIAL REPORTING ENVIRONMENT

1.3 MANAGEMENT ACCOUNTING

. 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 , for
example, budgets, which predict future revenue and expenditure.

Definition

, 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 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

There are a number of different ways of looking at a business. Some ideas are listed below.
 A business is a which exists to deal in the manufacture, re-sale
or supply of goods and services.
 A business is an to create goods or services which
customers will buy.
 A business is an for people.
 A business invests 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

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 of the business – sole traders
can have employees.
 FINANCIAL ACCOUNTING AND REPORTING | 11

Partnerships occur when 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 for
the amounts owed by their business, the shareholders of a limited liability company are only
responsible for the . This means that if the shareholders have
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, 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 , all three entities are treated as from their owners. This is called
the . 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 NON-COMMERCIAL UNDERTAKINGS

It is not only businesses that need to prepare financial statements. , for example,
may need to prepare financial statements every year. Financial statements also need to be prepared
for organisations (public sector organisations such as hospitals and local councils).

2 NATURE, PRINCIPLES AND SCOPE OF FINANCIAL

REPORTING

Section overview
 is the process of classifying, recording and presenting financial data in
accordance with generally established concepts and principles.

2.1 WHAT IS FINANCIAL REPORTING?

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 a business or
'reporting 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

(and company law in some countries) prescribe that a company should
. 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 Accounting Standards, which
are equivalent to issued by the
.
 12 | THE FINANCIAL REPORTING ENVIRONMENT

Large listed companies (sometimes known as public companies) are required to 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, 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 or
. They contain information which may be useful to a
. They are distinct from which are
prepared for a particular group of users and for a particular purpose. Share prospectuses and tax
computations are examples of special purpose financial reports.
Some users of published 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
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 and . 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 and (adding
together) information about transactions and other events. It also involves the effects of
continuous business transactions over separate accounting periods.
 Financial statements are based on . They
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 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
such as discussion of the risks and uncertainties that a business faces, or
a description of its effect on the natural environment.
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
(The answer is at the end of the module.)
 FINANCIAL ACCOUNTING AND REPORTING | 13

3 THE REPORTING ENTITY

Section overview
 A is an entity whose general purpose financial statements are relied upon
by other parties or users of the accounts.

A reporting entity is defined in Australia as 'an entity in respect of which it is reasonable to expect the
existence of users who rely on the entity's general purpose financial statements for information that
will be useful to them for making and evaluating decisions about the allocation of resources. A
reporting entity can be a single entity or a group comprising a parent and all of its subsidiaries'. Only
certain regulations will apply to the reporting entity.
The 'reporting entity' concept is not, however, one that is currently adopted outside Australia and at
present International standard-setters have no official equivalent definition. Internationally therefore, a
reporting entity is taken quite simply to be an entity, or group of entities, which prepare accounts. A
project is currently underway to develop an international 'reporting entity' concept.

4 USERS' AND SHAREHOLDERS' NEEDS

Section overview
 There are various groups of people who need information about the activities of a business.

4.1 THE NEED FOR FINANCIAL STATEMENTS

The purpose of financial statements is to provide useful information about the
and of an entity to a wide range of users.
Users need this information for two reasons:
1. to ; and
2. to .

4.1.1 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.

4.1.2 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.
 14 | THE FINANCIAL REPORTING ENVIRONMENT

4.2 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.
The following people are likely to be interested in financial information about a company with listed
shares.
 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.
 , 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.
 include suppliers who provide goods to the company on credit and customers who
purchase the goods or services provided by the company. want to know about the
company's ability to pay its debts; need to know that the company is a secure source of
supply and is in no danger of having to close down.
 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.
 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.
 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.
 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.
 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.
 . 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 of
these different groups. These information needs will differ between each user group and not all will be
equally satisfied.

4.3 NEEDS OF DIFFERENT USERS

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.
 FINANCIAL ACCOUNTING AND REPORTING | 15

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 to the business. Therefore they normally
to provide them with the information that they need.
For this reason, in most developed countries, including Australia, published

and their advisors.

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
D directors' remuneration
(The answer is at the end of the module.)

5 THE NEED FOR A REGULATORY FRAMEWORK

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.

5.1 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.

5.2 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.
 16 | THE FINANCIAL REPORTING ENVIRONMENT

Although these sources are the basis for the GAAP of individual countries, the concept also includes
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.
GAAP can be based on legislation and accounting standards that are either:
 prescriptive/rules-based; or
 principles-based.
The US operates a 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 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.)

5.2.1 INDIVIDUAL JUDGMENT

Financial statements are prepared on the basis of a number of
. 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.)

5.3 ADVANTAGES AND DISADVANTAGES OF REGULATION

The key benefit of accounting regulation is that it requires organisations to prepare financial
statements on a 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 , as their financial statements should
have been prepared on the same basis.
 FINANCIAL ACCOUNTING AND REPORTING | 17

Other include:
 The existence of accounting rules 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.
 Regulation means there will be rules as to what should be disclosed which improves the
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
accounting standards and (in some cases) companies legislation.
 The existence of regulation is likely to ensure that companies disclose 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 . 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 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 .
of regulation include:
 Strict regulation could mean a 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 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.
 18 | THE FINANCIAL REPORTING ENVIRONMENT

 Detailed rules and regulations may mean that companies spend a great deal of time ' '
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 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.
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.)

5.4 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.

5.4.1 COMPANY STRUCTURE AND OWNERSHIP

A country where the majority of companies are with few, if any, external shareholders
outside the family will need far less regulation than a country which is dominated by large
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
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.

5.4.2 LEVEL OF DEVELOPMENT

The level of development of a nation also has an impact on its level of regulation.
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.
 FINANCIAL ACCOUNTING AND REPORTING | 19

5.4.3 DIFFERENT PURPOSES OF FINANCIAL REPORTING

In some countries the purpose of preparing financial statements is solely for , and
therefore the accounting rules are often the same as the tax rules. In other countries, financial
statements exist to provide information for . This will have an impact on the
type of regulatory system in place.

5.4.4 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 groups
are given prominence, while in others enjoy a higher profile.

6 THE IFRS FOUNDATION AND THE IASB

Section overview
 The International regulatory framework consists of:
– 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.

6.1 SUBJECT OUTLINE

The 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
. 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 (established in 2009) provides a
. 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 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).
 20 | THE FINANCIAL REPORTING ENVIRONMENT

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.

6.2 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.
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.

6.3 OBJECTIVES OF THE IFRS FOUNDATION AND THE IASB

The formal objectives of the IFRS Foundation and IASB are:
 To develop, in the public interest, a single set of high quality, understandable, enforceable and
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 of those standards.
 To take account of the needs of a range of sizes and types of entities in diverse economic settings.
 To and of International Financial Reporting Standards (IFRS), being
the standards and interpretations issued through the IASB, through the convergence of national
accounting standards and IFRSs.

6.4 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 (as discussed above) and the
. The IASB has the sole responsibility for setting international financial
reporting standards.
 The (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 (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

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

6.5 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:
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.
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

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.
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.
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.
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 figure below:

RESEARCH

Discussion
paper (DP)
Optional

PUBLIC CONSULTATION

PROPOSAL Extensive
outreach
activities
Exposure
draft
(ED)
Input
into standard
setting process PUBLIC
CONSULTATION

Published Feedback
IFRS statement

IASB post-implementation review

6.6 CONSULTATION WITH NATIONAL STANDARD-SETTERS

The development of an IFRS involves an 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 ;
 participation in ;
 submission of a in response to a ;
 submission of a in response to an ;
 participation in ; and/or
 participation .
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.

6.7 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 to be , 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.

6.7.1 BENEFITS OF HARMONISATION

There are several :
 , both individual and corporate,
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
, because it provides them with on which to base economic
decisions. Users no longer have to understand several different national GAAPs or to incur the
of adjusting financial statements in order to compare them with each other.
 Harmonisation , because it makes it to the
between countries. It is into and in
countries other than their own.
 Robust international financial reporting standards are also needed to and to
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.

6.7.2 BARRIERS TO HARMONISATION

There are undoubtedly many barriers to full international harmonisation. Problems include the
following:
 . In some countries the purpose is solely for tax
assessment, while in others it is for investor decision-making.
 . These may prevent the development of certain accounting practices and
restrict the options available.
 . 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.
 . 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.
 is demonstrated in an unwillingness to accept another country's standard.
 result in objectives for accounting systems differing from country to country.
 FINANCIAL ACCOUNTING AND REPORTING | 25

 . 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.
 . 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
must therefore consider what the perceived advantages of harmonisation are, which justify so much
effort.

6.8 BENEFITS OF IFRS FOR NATIONAL JURISDICTIONS

The advantages of IFRS described above apply to individual nations. If it is possible to
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 ,
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:
 of Australian financial reports;
 for Australian multinational companies and foreign companies
operating in Australia and reporting elsewhere;
 facilitating more of the financial performance and financial position of
Australian and foreign reporting entities; and
 in Australia to best international practice.
There are a number of further potential benefits for national jurisdictions:
 Many who do not have the resources to develop and implement their own
national standards 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
that carry out operations within their territory. These companies would not be able to
'hide' behind foreign accounting practices which are difficult to understand.
 may find it easier to 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.

6.9 OTHER INTERNATIONAL INFLUENCES

There are a number of that have been involved in the recent trend of
moving to IFRS. They are discussed briefly below.

6.9.1 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.
 26 | THE FINANCIAL REPORTING ENVIRONMENT

6.9.2 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 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.

6.9.3 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.

6.9.4 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 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.

6.9.5 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
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, FRS 2 etc, and the Australian equivalents are AASB 1,
AASB 2 etc.

6.10 TRUE AND FAIR VIEW/FAIR PRESENTATION

It is a requirement of national legislation in some countries that the financial statements should give a
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 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.

6.11 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.

6.12 THE IASB AND FASB

The IASB and the 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.
 There are three main types of business entity: sole traders, partnerships and limited liability
companies.
 Non-commercial undertakings 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.
 A reporting entity is an entity whose general purpose financial statements are relied on by users of
accounts.
 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.
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 not correct?

 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.

A correct correct
B correct not correct
C not correct correct
D not correct not correct
4 Which of the following statements concerning the International Accounting Standards Board is
correct?
I. It develops and ultimately issues International Financial Reporting Standards (IFRSs).
II. The IASB is accountable to the International Accounting Standards Committee (IASC).

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?

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 regulation of company financial statements?

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

7 CONCEPTUAL FRAMEWORK AND GAAP

Section overview
 A conceptual framework is a statement of generally accepted theoretical principles which
form the frame of reference for financial reporting.
 There are advantages and disadvantages to having a conceptual framework.

7.1 THE SEARCH FOR A CONCEPTUAL FRAMEWORK

A 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
for determining which events should be accounted for, how they should be measured and how
they should be communicated to the user.

7.2 THE NEED FOR A CONCEPTUAL FRAMEWORK

Definition

A is a coherent system of interrelated objectives and fundamental concepts

that prescribes the nature, function and limits of financial accounting and reporting. (FASB)
A is 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: Exposure Draft of an
Improved Conceptual Framework for Financial Reporting, 2008)

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
and the
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.

7.3 ADVANTAGES AND DISADVANTAGES OF A CONCEPTUAL

FRAMEWORK

 The situation is avoided whereby standards are 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
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'.
 FINANCIAL ACCOUNTING AND REPORTING | 33

 The development of certain standards (particularly national standards) has been subject to
considerable 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
and reasoning behind standards based on principles.
 Standard setters may become 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 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
or other
guidance.
 The existence of a conceptual framework contributes to the of financial
reporting and in financial statements.

 Financial statements are intended for a , 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 (and with different concepts as a basis).
 It is not clear that a conceptual framework makes the task of
standards any easier than without a framework.
 In practice, conceptual frameworks can lead to accounting standards which are very
. 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 of financial information in making 'hold or
sell' . However, many users of financial statements are also
interested in information that will help them assess the of management.
 In addition, accounting principles : 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.

7.4 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

We defined 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).
34 | THE FINANCIAL REPORTING ENVIRONMENT

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 .
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 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"?
. 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.
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.

8 THE IASB'S CONCEPTUAL FRAMEWORK

Section overview
 The Conceptual Framework provides the theoretical framework for the development of
IFRS.

The IASB's Conceptual Framework for Financial Reporting is, in effect, the framework
upon which all IFRS are based and therefore determines how financial statements are prepared and
the information they contain.
 FINANCIAL ACCOUNTING AND REPORTING | 35

The Conceptual Framework consists of several sections or chapters, following on after a preface and
introduction. Some of these chapters have been adopted from the previous 'Framework for the
Preparation and Presentation of Financial Statements' and will be replaced in due course.
The chapters are as follows:
 the objective of general purpose financial reporting (see below);
 the reporting entity (not yet issued);
 qualitative characteristics of useful financial information (see later in this module); and
 the Framework 1989
– underlying assumption – going concern (see below)
– the elements of financial statements (see below)
– recognition of the elements of financial statements (see below)
– measurement of the elements of financial statements (see Module 2)
– concepts of capital and capital maintenance (see Module 2)

8.1 INTRODUCTION
The introduction to the Conceptual Framework points out the fundamental reason why financial
statements are produced worldwide, that is, to , 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 all aspects of financial statements, including
the regulations governing their accounting standards and their preparation and presentation.
The introduction emphasises the way financial statements are used to make economic decisions.

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.)

8.2 PURPOSE AND STATUS

The introduction gives a list of the purposes of the Conceptual Framework.
 assist the members of the IASB in the and in its review of existing
IFRS
 assist the members of the IASB in of regulations, accounting standards
and procedures relating to the presentation of financial statements by providing a basis for
reducing the number of alternative accounting treatments permitted by IFRS
 assist in developing national standards
 assist in applying IFRS and in dealing with topics that have yet
to form the subject of an IFRS
 assist in forming an opinion as to whether financial statements comply with IFRS;
 assist in interpreting the information contained in financial
statements prepared in compliance with IFRS
 provide those who are interested in the work of IASB with about its approach to the
formulation of IFRS
 36 | THE FINANCIAL REPORTING ENVIRONMENT

The Conceptual Framework itself is not an International Financial Reporting Standard and so does not
overrule any individual IFRS. In the rare cases of conflict between an IFRS and the Conceptual
Framework, the . 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.

8.3 SCOPE
The Conceptual Framework deals with:
 the of financial reporting;
 the that determine the usefulness of information in financial statements;
 the of the elements from which financial statements
are constructed; and
 concepts of .
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 (see
section 2.2).

9 THE OBJECTIVE OF GENERAL PURPOSE

FINANCIAL REPORTING

Section overview
 The Conceptual Framework states that:
'The objective of general purpose financial reporting is to provide financial information
about the reporting entity that is useful to existing and potential investors, lenders and
other creditors in making decisions about providing resources to the entity.'

These decisions involve buying, selling or holding share capital and debt instruments (such as loan
stock or debentures) and providing or settling loans and other forms of credit.
The Conceptual Framework explains that investors and lenders
for most of the financial information that they need. Therefore they are the
to which general purpose financial reports are directed.
The as the primary users of financial statements. Traditionally, in many
countries there has been a second objective of financial statements: to show the results of the
of management (the accountability of management for the resources entrusted to it).
The revised Conceptual Framework does not explicitly state this or use the term 'stewardship'. It does,
however explain that investors and other capital providers need information about how efficiently and
effectively the entity's management and governing board have discharged their responsibilities to use
the entity's resources. These responsibilities may include the protection of the entity's resources from
unfavourable effects of economic factors (such as price changes) and compliance with applicable laws
and regulations.
General purpose financial reports cannot provide all the information that investors, lenders and other
creditors need. They relevant , for
example, general economic conditions and expectations, political events and information about the
industry in which the company operates.
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.
 FINANCIAL ACCOUNTING AND REPORTING | 37

Question 6: Users of financial information

Earlier in this module, we discussed the users of accounting information. List the seven groups of users
and describe the information needs of each group.
(The answer is at the end of the module.)

9.1 ECONOMIC RESOURCES, CLAIMS AND CHANGES IN RESOURCES

AND CLAIMS
Financial reports provide information about the of an entity:
 its ; and
 the against it.
They also provide information about 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
and its and how successful it is likely to be in obtaining
it.

Definitions

. The availability of sufficient funds to meet financial commitments as they fall

due.
. The availability of cash over the to meet financial commitments as they fall
due.

in an entity's economic resources and claims result from its and also
from other transactions and events such as the issue of shares or an increase in debt (borrowings).
Information about a reporting entity's helps users to understand the
that the entity has produced on its economic resources. This is an indicator of
and is helpful in predicting future
returns.
Information about an entity's financial performance helps users to assess the entity's past and future
.
Information about a reporting entity's 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.

10 ACCOUNTING REGULATION

Section overview
 Accounting regulation is necessary to reduce subjectivity in producing financial reports and
to increase comparability.
 38 | THE FINANCIAL REPORTING ENVIRONMENT

10.1 ACCOUNTING STANDARDS

In an attempt to deal with some of the subjectivity that may occur in producing financial reports and to
achieve comparability between different organisations, were developed. These
standards are developed at both a national level (in most countries) and an international level. In this
Study Guide we are concerned with (IAS) and
(IFRS).
The role of accounting standards is discussed in more detail later in this module.

10.2 ACCOUNTING FOR SITUATIONS WHERE ACCOUNTING

STANDARDS DO NOT EXIST
When there is no specific legal regulation or accounting standard which covers an item in the
accounts, the accountant must make a decision on how this item will be dealt with in the financial
statements. It may be possible to account for the item following the accounting treatment of a similar
item. The accountant may need to make a judgment on the treatment of the item and account for it
so that the financial statements show a true and fair view or a fair presentation of the financial
performance and financial position of the entity.

10.3 USE OF CONCEPTUAL FRAMEWORK

A conceptual framework, such as the IASB Conceptual Framework can be beneficial in situations
where transactions are not covered by an accounting standard. The IASB's Conceptual Framework
includes definitions of the elements of financial statements, that is, assets, liabilities, equity, income
and expenses, and their recognition criteria. The Conceptual Framework also includes the qualitative
characteristics of financial information – these are the characteristics that financial information should
contain if it is to be useful to users. Therefore, the accountant will have sufficient information
contained within the Conceptual Framework to be able to exercise judgment and decide how to deal
with the transaction in a way that properly represents the underlying transaction.
For example, the accountant can refer to the definitions of assets and liabilities and consider whether
the transaction gives rise to new assets or new liabilities.
In this situation, the Conceptual Framework serves as a useful basis for accountants to refer to when
dealing with transactions not covered by an accounting standard. As the same recognition principles
are included in accounting standards, the outcome should be a consistent method of accounting
regardless of the detail in standards.

11 FUTURE DEVELOPMENTS

Section overview
 The IASB is currently developing a new Conceptual Framework.

11.1 REVISED FRAMEWORK

The IASB is carrying out a project to develop a new Conceptual Framework. This project originally
began as part of the process of convergence of IFRS and US GAAP (see earlier in this module).
The IASB has stated that the aim of the project to revise the Framework is to 'create a sound
foundation for future accounting standards that are principles-based, internally consistent and
internationally converged.'
 FINANCIAL ACCOUNTING AND REPORTING | 39

11.2 PROGRESS TO DATE

The current IASB Conceptual Framework for Financial Reporting consists of the original IASB
Framework for the Preparation and Presentation of Financial Statements (originally issued in 1989) with
some chapters replaced by those parts of the new Conceptual Framework that have been finalised.
To date the IASB has finalised chapters on the objectives and qualitative characteristics of financial
statements and has issued an Exposure Draft of a chapter on The Reporting Entity. These chapters
were developed jointly with the US FASB.
The FASB is no longer involved in the project and the IASB is developing the remainder of the new
Conceptual Framework alone.
In July 2013 the IASB issued a Discussion Paper: A Review of the Conceptual Framework for Financial
Reporting. This covers the issues that the IASB/FASB joint project had not yet addressed: definitions
of the elements of financial statements; recognition and derecognition; measurement; and
presentation and disclosure. The IASB does not intend to reconsider the objective of financial
statements or the qualitative characteristics of useful financial information.
Two exposure drafts (ED/2015/3 Conceptual Framework for Financial Reporting and ED/2015/4
Updating References to the Conceptual Framework were published in 2015. Currently the IASB expect
to publish a revised Conceptual Framework in late 2017. The revised framework will have some
significant differences, for example, they have updated the definition of assets and liabilities. The new
definitions will focus more on the fact that an asset is a resource and a liability is an obligation. The
IASB have also removed the notion of probability from the definitions.

12 ACCOUNTING POLICIES

Section overview
 Accounting policies are the specific principles, bases, conventions, rules and practices
adopted by an entity in preparing and presenting financial statements.
 An entity should select accounting policies that provide users of the financial statements
with information that is relevant and reliable in order to ensure that the financial statements
are prepared in accordance with GAAP.

are defined in IAS 8 Accounting Policies, Changes in Accounting Estimates and

Errors.

Definition

are the specific principles, bases, conventions, rules and practices adopted by an
entity in preparing and presenting financial statements.

You will see from this definition that companies have some choice in the matter of accounting policies.
How to apply a particular accounting standard, where a choice exists, is a matter of accounting policy.
How items are presented in the financial statements (including the notes), where alternative
presentations are allowed, is a matter of accounting policy. Policies should be chosen to comply with
IFRS, but with the overriding need for fair presentation.
The first note to a company's financial statements is the disclosure of accounting policies. This may
include the depreciation policy and other issues, such as valuation of inventory or revaluation of non-
current assets.
Another term used is , sometimes called . These involve
the use of judgment when applying accounting policies. For instance, the accounting policy may state
that non-current assets are depreciated over their expected useful life. The decision regarding the
 40 | THE FINANCIAL REPORTING ENVIRONMENT

length of useful life is a matter of . The decision regarding method of depreciation is also a
matter of estimation, rather than accounting policy.
There is the further matter of . Is the value of the asset, upon which its
depreciation is based, stated at original cost or revalued amount or current replacement cost? This is
the measurement basis and will be stated in the accounting policy. The company must disclose in the
notes to the accounts any change of accounting policy. Any change in is
regarded as a change of accounting policy and must be disclosed. Any change in
is not a change of accounting policy; however the effects of such a change on the current
and future periods should be disclosed.

12.1 OBJECTIVES IN SELECTING ACCOUNTING POLICIES

In selecting accounting policies, businesses should seek to satisfy two primary criteria: relevance and
reliability. These criteria are characteristics of useful financial information.
The IASB's Conceptual Framework for Financial Reporting uses the terms and
. We will look at the characteristics of useful financial information in more detail in the
next module.

12.1.1 RELEVANCE
Appropriate accounting policies will result in the presentation of financial information.
Financial information is relevant if it is:
 capable of influencing the economic decisions of users; and
 provided in time to influence those decisions.
Relevant information possesses either predictive or confirmatory value or both.

12.1.2 FAITHFUL REPRESENTATION

Financial information meets the faithful representation criterion if:
 it reflects the that is, represents faithfully what has taken place;
 it is free from bias, or is ;
 it is free from ;
 it is ; and
 (caution) has been applied where there is any uncertainty.

Question 7: Accounting policy

Decide whether or not these represent a change of accounting policy:

(a) The company has previously included certain overheads within cost of sales. It now proposes to
show those overheads within administrative expenses.
(b) A company has previously depreciated vehicles using the reducing balance method at 40 per cent
per year. It now proposes to depreciate vehicles using the straight-line method over five years.
(c) A company has previously measured inventory at weighted average cost. It now proposes to
measure it on a First In, First Out (FIFO) basis.
(The answer is at the end of the module.)
 FINANCIAL ACCOUNTING AND REPORTING | 41

13 IAS 8 ACCOUNTING POLICIES, CHANGES IN

ACCOUNTING ESTIMATES AND ERRORS

Section overview
 IAS 8 deals with the treatment of changes in accounting estimates, changes in accounting
policies and errors.

13.1 DEFINITIONS
The following definitions are given in IAS 8:

Definitions

are the specific principles, bases, conventions, rules and practices adopted by an
entity in preparing and presenting financial statements.
A is an adjustment of the carrying amount of an asset or a liability or
the amount of the periodic consumption of an asset, that results from the assessment of the present
status of, and expected future benefits and obligations associated with, assets and liabilities. Changes
in accounting estimates result from new information or new developments and, accordingly, are not
corrections of errors.
: Omissions or misstatements of items are if they could, individually or collectively,
influence the economic decisions that users make on the basis of the financial statements. (This is very
similar to the definition in the Conceptual Framework.)
are omissions from, and misstatements in, the entity's financial statements for one
or more prior periods arising from a failure to use, or misuse of, reliable information that:
 was available when financial statements for those periods were authorised for issue; and
 could reasonably be expected to have been obtained and taken into account in the preparation
and presentation of those financial statements.
Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies,
oversights or misinterpretations of facts, and fraud.
is applying a new accounting policy to transactions, other events and
conditions as if that policy had always been applied.
is correcting the recognition, measurement and disclosure of amounts of
elements of financial statements as if a prior period error had never occurred.
of a change in accounting policy and of recognising the effect of a change in
an accounting estimate, respectively, are:
 applying the new accounting policy to transactions, other events and conditions occurring after the
date as at which the policy is changed; and
 recognising the effect of the change in the accounting estimate in the current and future periods
affected by the change.
Applying a requirement is impracticable when the entity cannot apply it after making
every reasonable effort to do so. It is impracticable to apply a change in an accounting policy
retrospectively or to make a retrospective restatement to correct an error if one of the following apply:
 The effects of the retrospective application or retrospective restatement cannot be determined.
 The retrospective application or retrospective restatement requires assumptions about what
management's intent would have been in that period.
 42 | THE FINANCIAL REPORTING ENVIRONMENT

 The retrospective application or retrospective restatement requires significant estimates of

amounts and it is impossible to distinguish objectively information about those estimates that:
– provides evidence of circumstances that existed on the date(s) at which those amounts are to
be recognised, measured or disclosed; and
– would have been available when the financial statements for that prior period were authorised
for issue, from other information.
(IAS 8)

13.2 DETERMINING ACCOUNTING POLICIES

Accounting policies are determined by and considering any relevant
Implementation Guidance issued by the IASB for that IFRS.
Where there is no applicable IFRS management should use its in developing and applying
an accounting policy that results in information that is and .
Management should refer to:
 the requirements of IFRS dealing with and ; and
 the definitions, recognition criteria and measurement concepts for assets, liabilities and expenses
in the Conceptual Framework.
Management may also consider the most recent pronouncements of
that use a similar conceptual framework to develop Standards, other accounting literature and
accepted industry practices if these do not conflict with the sources above.
An entity must select and apply its accounting policies for a period for similar
transactions, other events and conditions, unless an IFRS specifically requires or permits categorisation
of items for which different policies may be appropriate. If an IFRS requires or permits categorisation
of items, an appropriate accounting policy must be selected and applied consistently to each
category.

13.3 CHANGES IN ACCOUNTING POLICIES

Changes in accounting policy are normally applied retrospectively.
The same accounting policies are usually adopted from period to period, to allow users to analyse
trends over time in profit, cash flows and financial position.
and should be made only if:
 the change is required by an ;
 the change will result in a of events or transactions in the
financial statements of the entity.

13.3.1 ADOPTION OF AN IFRS

Where a new IFRS is adopted, IAS 8 requires any transitional provisions in the new IFRS itself to be
followed. If none are given in the IFRS which is being adopted, then the general principles of IAS 8
should be followed.

13.3.2 OTHER CHANGES IN ACCOUNTING POLICY

IAS 8 requires , unless it is to determine the cumulative
amount of change. Any resulting adjustment should be reported as an adjustment to the opening
balance of retained earnings. Comparative information should be restated unless it is impracticable to
do so.
This means that all comparative information must be restated
, with amounts relating to earlier periods reflected in an adjustment to opening reserves of the
earliest period presented.
 FINANCIAL ACCOUNTING AND REPORTING | 43

There is . Where an entity for the first time this is treated as

a revaluation under IAS 16 Property, Plant and Equipment, not as a change of accounting policy under
IAS 8. Therefore it is not applied retrospectively.
If, at the beginning of the current period, it is impracticable to determine the cumulative effect of
applying a new accounting policy to periods, the entity should adjust the comparative
information to apply the new accounting policy only.

13.3.3 DISCLOSURES
Certain are required when a change in accounting policy has a material effect on the
current period or any prior period presented, or when it may have a material effect in subsequent
periods:
 reasons for the change
 amount of the adjustment for the current period and for each period presented
 amount of the adjustment relating to periods prior to those included in the comparative
information
 the fact that comparative information has been restated or that it is impracticable to do so
An entity should also disclose information relevant to assessing the on the
financial statements where these have .

Question 8: Change in accounting policy

During the year ended 31 December 20X7 MM Manufacturing decided to change its accounting
policy for inventory valuation from FIFO to weighted average.
Extracts from the financial statements for 20X6 (final) and 20X7 (draft) prior to this change were as
follows:

Sales 50 000 54 000

Cost of goods sold (24 000) (26 000)
Profit before taxes 26 000 28 000
Income taxes ( 30%) (7 800) (8 400)
Profit for the period 18 200 19 600

The estimated values of MM's inventory under the FIFO and weighted average methods were as
follows:

FIFO 2 800 2 900 2 950

Weighted average 2 700 2 750 2 870
Required
Show the impact of this change of policy on the statement of profit or loss for 20X7, with the 20X6
comparative.
(The answer is at the end of the module.)

13.4 CHANGES IN ACCOUNTING ESTIMATES

Changes in accounting estimate are applied retrospectively.
Estimates arise in relation to business activities because of the .
Judgments are made based on the most up to date information and the use of such estimates is a
necessary part of the preparation of financial statements. It does not undermine their reliability. Here
are some examples of accounting estimates:
 a necessary
 of depreciable assets
 provision for
 44 | THE FINANCIAL REPORTING ENVIRONMENT

The rule here is that the should be accounted for

prospectively that is, it should be included in profit before tax or loss in either:
 the period of the change, if the change affects that period only; or
 the period of the change and future periods, if the change affects both.
An example of a change in accounting estimate which affects only the is the
irrecoverable debt estimate. However, a revision in the life over which an asset is depreciated would
affect both the , in the amount of the depreciation expense.
The effect of a change in an accounting estimate should be included in the
as was used previously for the estimate. This rule helps to ensure between
the financial statements of different periods.
The of the change is also relevant. The nature and amount of a change in an accounting
estimate that has a material effect in the current period (or which is expected to have a material effect
in subsequent periods) should be disclosed. If it is not possible to quantify the amount, this
impracticability should be disclosed.

Question 9: Change in accounting estimate

On 1 January 20X3, an asset was purchased by MM Manufacturing for $100 000. It had an estimated
useful economic life of 10 years, and was depreciated on the straight line basis. On 31 December 20X7
a review of non-current assets indicated that the asset would continue to be useable until
31 December 20X9.
Required
Explain the accounting treatment for this asset.
(The answer is at the end of the module.)

13.5 ERRORS
Material prior period errors must be corrected .
Errors discovered during a current period which may arise through:
 mathematical mistakes;
 mistakes in the application of accounting policies;
 misinterpretation of facts;
 oversights; and/or
 fraud.
Most of the time these errors can be
. Where they are , however, this is not appropriate.

13.5.1 ACCOUNTING TREATMENT

Material prior period errors must be corrected retrospectively.
This involves:
(a) either restating the comparative amounts for the prior period(s) in which the error occurred; or
(b) when the error occurred before the earliest prior period presented, restating the opening balances
of assets, liabilities and equity for that period
so that the financial statements are presented .
Only where it is to determine the cumulative effect of an error on prior periods can an
entity correct an error .
 FINANCIAL ACCOUNTING AND REPORTING | 45

Various are required:

(a) the of the prior period error;
(b) for each prior period, to the extent practicable, the of the correction:
(i) for each financial statement line item affected.
(ii) for basic and diluted earnings per share (if disclosed);
(c) the amount of the correction at the presented; and
(d) if for a particular prior period, the that
led to the existence of that condition and a description of how and from when the error has been
corrected. Subsequent periods need not repeat these disclosures.

Question 10: Error

During 20X7 Global discovered that certain items had been included in inventory at 31 December
20X6, valued at $4.2m, which had in fact been sold before the year end. The following figures for 20X6
(as reported) and 20X7 (draft) are available.

Sales 47 400 67 200

Cost of goods sold (34 570) (55 800)
Profit before taxation 12 830 11 400
Income taxes (3 849) (3 420)
Profit for the period 8 981 7 980

Retained earnings at 1 January 20X6 were $13m. The cost of goods sold for 20X7 includes the $4.2m
error in opening inventory. The income tax rate was 30 per cent for 20X6 and 20X7. No dividends have
been declared or paid.
Required
Show the statement of profit or loss and other comprehensive income for 20X7, with the 20X6
comparative, and retained earnings.
(The answer is at the end of the module.)
46 | THE FINANCIAL REPORTING ENVIRONMENT

KEY MODULE POINTS 2

 A conceptual framework is a statement of generally accepted theoretical principles which form the
frame of reference for financial reporting.
 There are advantages and disadvantages to having a conceptual framework.
 The IASBs Conceptual Framework for Financial Reporting provides the theoretical framework for
the development of IFRS. The Conceptual Framework is being progressively updated by the IASB.
 The Conceptual Framework states that:
'The objective of general purpose financial reporting is to provide financial information about
the reporting entity that is useful to existing and potential investors, lenders and other creditors
in making decisions about providing resources to the entity.'
 The IASB has been developing a new Conceptual Framework and it is expected to be published
late in 2017.
 Accounting policies are the specific principles, bases, conventions, rules and practices adopted by
an entity in preparing and presenting financial statements.
 An entity should select accounting policies that provide users of the financial statements with
information that is relevant and reliable.
 IAS 8 deals with the treatment of changes in accounting estimates, changes in accounting policies
and errors.
 A change in accounting policy is only allowed where it is required by legislation, by a new
accounting standard or when it will result in more appropriate presentation.
 A change in accounting policy is applied retrospectively.
 A change in accounting estimate is applied prospectively.
 A prior period error is corrected retrospectively.
 FINANCIAL ACCOUNTING AND REPORTING | 47

QUICK REVISION QUESTIONS 2

1 A conceptual framework is
A the proforma financial statements.
B a list of key terms used by the IASB.
C a theoretical expression of accounting standards.
D a statement of theoretical principles which form the frame of reference for financial reporting.

2 Which of the following is an advantage of a conceptual framework?

A A framework encourages standardised accounting practice.
B The framework does not simplify the preparation and implementation of standards.
C There are a variety of users, so not all will be satisfied with the content of the framework.
D There are a variety of accounting situations which mean flexibility in the accounting approach is
needed.

3 What is the name of the IASB's conceptual framework?

A Statement of Principles for Financial Reporting
B The Conceptual Framework for Financial Reporting
C The Conceptual Framework for the Disclosure of Financial Statements
D The Conceptual Framework for the Presentation of Financial Statements to Users

4 What is the fundamental reason that financial statements are produced, according to the preface
of the IASB's Conceptual Framework?
A to provide information to tax authorities
B to satisfy the requirements of external users
C to provide information for internal management
D to report on a company's performance to its national government

5 Which of the following are uses of financial statements prepared by a company?

I. inclusion in national income statistics
II. decisions to buy, hold or sell equity investments
III. assessment of the security of amounts lent to the entity
IV. assessment of management stewardship and accountability

A I and II only
B II and IV only
C III and IV only
D I, II, III and IV

6 According to the Conceptual Framework, who are the most important users of general purpose
financial reports?
A investors and lenders
B investors and employees
C lenders and management
D investors and the government

7 If an accountant comes across a transaction that is not covered by an accounting standard, where
should they look for guidance on accounting for that item?
A UK GAAP
B US GAAP
C company law
D conceptual framework
48 | THE FINANCIAL REPORTING ENVIRONMENT

8 Which of the following constitute a change of accounting policy according to IAS 8 Accounting
Policies, Changes in Accounting Estimates and Errors?
I. a change in depreciation method
II. a change in the basis of valuing inventory
III. adopting an accounting policy for a new type of transaction not previously dealt with
IV. a decision to capitalise borrowing costs relating to the construction of non-current assets, rather
than writing them off as incurred

A I and II only
B I and III only
C I and IV only
D II and IV only

9 Which of the following items would qualify for treatment as a change in accounting estimate,
according to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors?
I. provision for obsolescence of inventory
II. correction necessitated by a material error
III. a change in the useful life of a non-current asset
IV. a change as a result of the adoption of a new International Accounting Standard

A I and III only

B I and IV only
C II and III only
D I, II, III and IV
 FINANCIAL ACCOUNTING AND REPORTING | 49

14 THE ROLE OF ACCOUNTING STANDARDS

Section overview
 There are two different approaches to developing accounting standards: principles-based,
and rules based. Principles-based standards are developed according to a set of laid down
principles. Rules-based standards regulate for issues as they arise. Both these approaches
have advantages and disadvantages.
 Accounting standards are authoritative statements of how particular types of transactions
and other events should be reflected in the financial statements.

14.1 SUBJECT OUTLINE

The next few sections of this module will examine the purpose of accounting standards as the means
of setting out the accounting rules to be followed. First, we will discuss the two different methods of
setting accounting rules, the principles-based and rules-based approaches and then look at the role of
accounting standards in more detail.

14.2 PRINCIPLES-BASED VERSUS RULES-BASED SYSTEMS

A principles-based system works within a set of defined principles. A rules-based system regulates for
issues as they arise. Both of these have advantages and disadvantages.
The IASB's Conceptual Framework for Financial Reporting is intended to provide the underlying
principles within which standards can be developed. One of the main purposes of a conceptual
framework is to ensure that standards are not produced which are in conflict with each other. In
addition, any departure from a standard can be judged on the basis of whether or not it is in keeping
with the principles set out in the Conceptual Framework. A system of accounting is
a .
The opposite of a principles based system is a , in which there are a number of
detailed regulations designed to cover every eventuality.
In practice, most standard setting bodies, including the IASB, have developed or adopted standards
that are a mixture of principles and rules. IFRS can currently be viewed as a 'hybrid' system: there is a
conceptual framework and many standards are principles-based, but some standards (mainly those
influenced by US GAAP) are rules-based.

14.3 THE DIFFERENCES BETWEEN A PRINCIPLES-BASED SYSTEM AND A

RULES-BASED SYSTEM
A rules-based system requires preparers to understand and to report specific
transactions.
A principles-based system requires preparers to in order to develop accounting
policies to report specific types of transactions and events.
Consider accounting for tangible non-current assets. An extreme rules-based approach would set out
precise requirements for each type of asset, for example:
'Plant and equipment should be depreciated on the straight line basis over a period not exceeding
four years.'
A principles-based approach would contain more general requirements, for example:
'The depreciable amount of an asset shall be allocated on a systematic basis over its useful
life…The depreciation method used shall reflect the pattern in which the asset's future economic
benefits are expected to be consumed by the entity.' (IAS 16 Property, Plant and Equipment)
50 | THE FINANCIAL REPORTING ENVIRONMENT

Rules-based accounting standards often need to contain complex .

For example, if plant and equipment must be depreciated over four years, while other classes of asset
are depreciable over a longer period, the standard must define what is meant by plant and
equipment. Standards often contain further material that explains and interprets the rules and this in
turn may be supplemented by guidance and regulations relating to particular industries or types of
transaction. As a result, accounting standards and guidance can be .
has the following advantages:
 in theory, it results in financial statements being between entities (or between entities
in the same industry);
 it may (as in theory there is
only one allowed accounting treatment for each type of transaction or event);
 it is suitable for (such as the US); and
 it in almost all situations; preparers and
risk the consequences (e.g. litigation or reputational damage if a user makes a wrong decision
based on information in the financial statements).
Principles-based accounting standards are likely to be less lengthy and complex than rules-based
standards, with fewer definitions and scope exceptions.
There may be an explicit requirement that the financial statements show a of the
entity's financial performance and financial position and that this requirement should override all
others. An entity may depart from a requirement if management is convinced that this is necessary
(normally in exceptional circumstances).
Standards normally require of information about the nature of transactions or
events and the accounting policies adopted. This is seen as necessary in order for users to understand
the information that is being presented in the financial statements and to make meaningful
comparisons between different entities.
In practice, principles based standards often need to be accompanied or supported by
The IASB has a separate operating body that
issues interpretations of standards where interpretation difficulties arise, while the Australian
Accounting Standards Board appoints Interpretation Advisory Panels on an ad hoc basis.
A purely or mainly has the following advantages:
 in theory, it is more likely than a rigid-rules based system to result in financial statements that show
a ;
 it encourages the use of ;
 it is as principles are harder to evade than rules; and
 arguably it is than a system of rules and can therefore cope better with a rapidly
changing business and economic environment.
See also the advantages of a conceptual framework we covered earlier in this module; many of these
also apply here.

Question 11: What type of standard?

Below are extracts from IAS 38 Intangible Assets:

Research is original and planned investigation undertaken with the prospect of gaining new scientific
or technical knowledge and understanding.
Development is the application of research findings or other knowledge to a plan or design for the
production of new or substantially improved materials, devices, products, processes, systems or
services prior to the commencement of commercial production or use.
No intangible asset arising from research shall be recognised. Expenditure on research shall be
recognised as an expense when it is incurred.
 FINANCIAL ACCOUNTING AND REPORTING | 51

An intangible asset arising from development activities shall be recognised if and only if an entity can
demonstrate specific conditions.
Required
(a) What type of standard is this, rules-based or principles-based?
(b) Explain why the requirements above might the usefulness of the information in the financial
statements.
(The answer is at the end of the module.)

14.4 THE PURPOSE OF ACCOUNTING STANDARDS

Definition

Accounting standards are authoritative statements of how particular types of

transactions and other events should be reflected in the financial statements.

Accounting standards form part of the Generally Accepted Accounting Principles (GAAP) that sets out
the accounting rules that companies must abide by. They are structured to provide detailed guidance
on accounting for a particular item. For example, there are a number of accounting standards that
deal with the accounting treatment of items recognised in the financial statements such as non-current
assets, provisions and liabilities.
Accounting standards are of key importance in the regulation process as they provide the detailed rules
on dealing with transactions and disclosures in the financial statements. Without this detailed guidance,
companies would be free to account for transactions as they wished, which would firstly reduce the
comparability of financial statements and secondly, could lead to misleading accounts if companies
report transactions in a more favourable light. Neither of these options would be beneficial to users of
the financial statements.
In many countries, including Australia, accounting standards have the force of law. Some or all limited
liability companies are required to comply with them in preparing financial statements. Listing
authorities also require compliance with standards as a condition of obtaining a stock exchange
listing. In some countries, including Australia and the UK, some not for profit entities and
governmental organisations may also be required to comply with accounting standards.
Even where compliance is not an actual legal requirement (for example, for a small or unincorporated
entity) the requirements of accounting standards are normally taken to represent 'best practice'.

14.4.1 ACCOUNTING STANDARDS AND THE CONCEPTUAL FRAMEWORK

We have already seen that a conceptual framework exists to provide a basis for the preparation of
financial statements. In theory, accounting standards should be with the principles of the
conceptual framework. For example, any accounting standard dealing with the recognition of assets
should include the definition of an asset from the conceptual framework as well as the relevant
recognition criteria.
One of the stated purposes of the IASB's Conceptual Framework is to assist in applying IFRS. Where
there is no accounting standard covering a particular transaction, the Conceptual Framework can be
used to assist in developing an appropriate accounting treatment.

14.4.2 ACCOUNTING STANDARDS AND A FAIR PRESENTATION

The objective of financial statements is to provide information about the financial position and
performance of an entity. Financial information should show a or true and fair view
of the activities of an entity.
 52 | THE FINANCIAL REPORTING ENVIRONMENT

Like 'true and fair view', 'present fairly' is not defined in the Conceptual Framework or in any IFRS.
However, IAS 1 Presentation of Financial Statements explains that:
 Fair presentation requires the of the effects of transactions, other events
and conditions in accordance with the definitions and recognition criteria for assets, liabilities,
income and expenses set out in the Conceptual Framework.
 with additional disclosure where necessary, is
financial statements that achieve a .
We will examine the meaning of later in this module.
The following points made by IAS 1 expand on this principle:
 If an entity has , it should disclose that fact in its financial statements.
 must be followed if compliance with IFRS is disclosed.
 Use of an cannot be rectified either by disclosure of
accounting policies or notes/explanatory material.
Fair presentation involves more than mere compliance. Preparers should apply the 'spirit' (or
) behind an accounting standard as well as the strict 'letter'. The requirement to 'present
fairly' also applies to transactions which are
Fair presentation requires an entity to:
 select and apply ;
 in a manner that results in relevant, reliable, comparable and understandable
information; and
 where these are necessary to enable users to understand the
impact of particular transactions, other events and conditions on an entity's financial performance
and position.
IAS 1 states that (explanatory material or notes)
.

15 ACCOUNTING STANDARDS AND CHOICE

Section overview
 There are arguments for and against having accounting standards.

It is sometimes argued that having accounting standards actually the quality of financial
reporting, and that individual companies should be given more over how they report
transactions. There are arguments on both sides.
Many of the advantages and disadvantages of accounting standards are similar to the advantages and
disadvantages of accounting regulation in general which we covered earlier in this module.

15.1 ADVANTAGES OF ACCOUNTING STANDARDS

Standards have the following :
 They in the methods used to prepare accounts and so
of financial information. Users of financial statements need to be able to
an entity's financial performance and position with those of other, similar entities. They
also need to be able to compare the performance and position of an entity over time, in order to
evaluate trends. (For example, have sales increased or decreased compared with those of the
previous period?)
 FINANCIAL ACCOUNTING AND REPORTING | 53

 They make it for preparers to adopt accounting treatments that

. Without accounting standards management could adopt the accounting
treatments that produced the highest reported profit and the strongest financial position possible,
even if these did not give a fair presentation.
 They to preparers of financial statements. The business environment is
becoming increasingly complex and some preparers may find it difficult to determine the
appropriate accounting treatment for many types of transaction or event (for example, those
involving derivative financial instruments or arrangements whose economic substance is not the
same as their legal form).
 Financial statements prepared in accordance with accounting standards are based on generally
accepted accounting practice and arguably this makes them than they
would otherwise be.
 They generally of general purpose financial reporting. Standards require
entities to accounting information than they would otherwise have done if
standards did not exist. This information includes the used in the preparation
of the financial statements. As well as increasing the amount of information that is available, in
theory, standards help to ensure that the financial statements actually do provide
.
 They provide a focal point for about accounting practice and in that way
contribute to the development of best practice.
 They are a about the way in which particular items should be
treated. The development of IFRS involves a full in which users and preparers
are able to be directly involved.
 They are a to enforcing conformity by means of legislation.
 They of financial reporting generally. Users are more likely to trust financial
information if it has been prepared in accordance with accounting standards and other regulation
than if they would be if standards did not exist.

15.2 DISADVANTAGES OF ACCOUNTING STANDARDS

The of accounting standards are as follows:
 Not all entities are the same size or operate in the same industry.
The use of an inappropriate
accounting treatment may actually reduce the quality of the information provided.
 The development of accounting standards and other regulation is a and may be
affected by . Although anyone can comment on a proposed
standard, most commentators tend to be large listed companies or large professional firms:
organisations with considerable power to influence standard setters in their own interests.
 Most recent standards have been developed to meet the needs of providers of capital to large
public companies. For many smaller entities, (both in time and money)
outweigh the benefits to users.
 Accounting standards . Some
preparers view them as a through 'creative accounting'. (This is
less likely if standards are based on principles and concepts rather than detailed rules.)
 Earlier standards were not based on a of accounting. This means that they
may be inconsistent with one another. The IASB is committed to rectifying this.
 There may be a , and away from flexibility in applying the rules. Some
commentators believe that preparers should be free to use their professional judgment on
technical matters.
 Accounting standards often require . It can be argued that this makes
financial statements and less useful.
 54 | THE FINANCIAL REPORTING ENVIRONMENT

 Accounting standards may have for the entities who have to

apply them and for others and taken by management. For
example, a company might avoid particular actions (such as investment in certain types of asset)
that might benefit it in the long term, if they were required to treat the transactions in a way that
dramatically reduced reported profit.

Case study: Economic consequences

The UK standard FRS 17 Accounting for Retirement Benefits changed the financial reporting treatment
of some types of pension scheme (defined benefit schemes). This had the effect of significantly
increasing the non-current liabilities of the companies that operated those schemes. As a result, most
companies which operated defined benefit schemes closed them to new entrants and replaced them
with pension arrangements that were much less advantageous to their employees.
It has been argued that accounting standards should reflect economic reality (e.g. companies that
operate defined benefit schemes have a liability for the cost of providing pensions in future periods)
and standard setters should not concern themselves with the possible consequences of requiring a
particular accounting treatment. Recently, however, following the global economic crisis, a few
commentators and politicians have begun to question this.

16 ACCOUNTING CONCEPTS

Section overview
 is an underlying assumption in preparing financial statements. It is the main
underlying assumption stated in the Conceptual Framework.
 Financial information (other than information about cash flows) should be prepared on an
basis.

16.1 GOING CONCERN

Definition

. The entity is normally viewed as a going concern, that is, as continuing in operation
for the foreseeable future. It is assumed that the entity has neither the intention nor the need to
liquidate or curtail materially the scale of its operations. (Conceptual Framework)

This concept assumes that, when preparing a normal set of accounts, the business will
in approximately the same manner for the foreseeable future (at least the next 12 months).
In particular, the entity will not go into liquidation or scale down its operations in a material way.
The main significance of a business being a going concern is that:
1. Assets that is the amount they would sell for if
they were sold off piecemeal and the business was broken up (unless the assets satisfy the
requirements of IFRS 5 Non-current Assets Held for Sale and Discontinued Operations). If assets
are classified as held for sale in accordance with IFRS 5, they should be measured at the lower of
carrying amount and fair value less costs to sell.
2. Liabilities are classified as current or non-current depending on when they are due to be settled.

16.1.1 EXAMPLE: GOING CONCERN

Emma acquires a T-shirt printing machine at a cost of $60 000. The asset has an estimated life of six
years with a scrap value of nil at the end of six years, and it is normal to write off the cost of the asset
to the statement of profit or loss over this time. In this case a depreciation cost of $10 000 per year is
charged.
 FINANCIAL ACCOUNTING AND REPORTING | 55

Using the going concern assumption, it is presumed that the business will continue its operations and
so the asset will produce economic benefits throughout its full six years in use. A depreciation charge
of $10 000 is made each year, and the value of the asset in the statement of financial position is its cost
less the accumulated depreciation charged to date. After one year, the of the asset
is $(60 000 – 10 000) = $50 000, after 2 years it is $40 000, after 3 years $30 000 and so on, until it is
written down to a value of 0 after 6 years.
This asset has no other operational use outside the business and, in a forced sale, it would only sell for
scrap. After one year of operation, its scrap value is $8000.
The carrying amount of the asset, applying the going concern assumption, is $50 000 after 1 year, but
its immediate sell-off value only $8000. It can be argued that the asset is over-valued at $50 000, that it
should be written down to its break-up value ($8000) and the balance of its cost should be treated as
an expense. However, provided that the going concern assumption is valid, it is appropriate
accounting practice to value the asset at its carrying amount.

Question 12: Going concern

A retailer commences business on 1 January and buys inventory of 20 washing machines, each costing
$100. During the year they sell 17 machines at $150 each. How should the remaining machines be
valued at 31 December in the following circumstances?
(a) They are forced to close down the business at the end of the year and the remaining machines will
realise only $60 each in a forced sale.
(b) They intend to continue the business into the next year.
(The answer is at the end of the module.)

, that fact must be disclosed, together with:

 the basis on which the financial statements have been prepared; and
 the reasons why the entity is not considered to be a going concern.

16.2 ACCRUALS BASIS OF ACCOUNTING

Definition
In the , items are recognised as assets, liabilities, equity, income and
expenses (the elements of financial statements) when they satisfy the definitions and recognition
criteria for those elements in the Conceptual Framework. (IAS 1)

Entities should prepare their financial statements on the basis that transactions are recorded in them,
not as the cash is paid or received, but as the revenues or expenses are in the
accounting period to which they relate.
According to the accruals assumption, profit is computed as the surplus/(deficit) of revenue and
expenses. In computing profit, revenue earned must be the expenditure incurred in
earning it. This is also known as the .

16.2.1 EXAMPLE: ACCRUALS

Emma prints 20 T-shirts in her first month of trading (May) at a cost of $5 each (purchased on credit
terms). She then sells all of them for $10 each. Emma has therefore made a profit of $100, the surplus
of revenue ($200) earned over the cost ($100) of acquiring them.
If, however, Emma only sells 18 T-shirts, it is incorrect to charge her statement of profit or loss (income
statement) with the cost of 20 T-shirts, as she still has 2 T-shirts in inventory. If she sells them in June,
she is likely to make a profit on the sale. Therefore, the profit is $90, the surplus of sales revenue ($180)
over the purchase cost of 18 T-shirts ($90).
 56 | THE FINANCIAL REPORTING ENVIRONMENT

Her statement of financial position will look like this.

Inventory (at cost, i.e. 2 × $5) 10

Accounts receivable (18 × $10) 180
190

Proprietor's capital (profit for the period: 18 × $5) 90

Accounts payable (20 × $5) 100
190

However, if Emma had decided to give up selling T-shirts, then the going concern assumption no
longer applies and the value of the 2 T-shirts in the statement of financial position is break-up
valuation, not cost. Similarly, if the 2 unsold T-shirts are unlikely to be sold at more than their cost of $5
each (say, because of damage or a fall in demand) then they should be recorded on the statement of
financial position at their (i.e. the likely eventual sales price less any expenses
incurred to make them saleable, i.e. say, $4 each) rather than cost. This shows the application of the
, which we will discuss shortly.
In this example, the concepts of going concern and accruals are linked. Since the business is assumed
to be a going concern, it is possible to carry forward the cost of the unsold T-shirts as a charge against
profits of the next period.

16.3 SUBSTANCE OVER FORM

Faithful representation of a transaction is only possible if it is accounted for according to its
, not solely based on its legal form.

Definition

. The principle that transactions and other events are accounted for and
presented in accordance with their substance and economic reality and not merely their legal form.

For instance, one party may sell an asset to another party and the sales documentation may record
that legal ownership has been transferred. However, if agreements exist whereby the party selling the
asset continues to enjoy the future economic benefits arising from the asset, then in substance no sale
has taken place.
An example of substance over form is found in . A lease is a contract that
conveys the right to use an asset for a period of time. In a lease the lessee never obtains legal title to
the asset so does not own that asset. However, they have all the risks and rewards of ownership, such
as the right to use the asset for most, if not all, of its useful life and they must bear the costs of
ownership such as insurance and maintenance. For this reason, the asset is in the lessee's
accounts and treated as an owned asset, following the substance of the transaction. This accounting
treatment will ensure that the financial statements show the true financial position of the entity, and
does not hide assets and liabilities from the statement of financial position.
In accounting for the lease above, if the legal form was followed, the asset and the lease liability would
not be recognised which would make the financial statements look better than they actually are. This
has the effect of improving the gearing ratio, as the liability is not recorded, it also improves the return
on capital employed, as the asset base is lower. Hence following substance over form is key in
showing a fair presentation of the financial statements of an entity.
 FINANCIAL ACCOUNTING AND REPORTING | 57

Case study: Repo 105

After the investment bank, Lehman Brothers, collapsed in 2008 it was discovered that the bank had
used a transaction known as 'Repo 105' to raise short-term finance. Financial assets were swapped for
cash but with an agreement to buy them back at a future date. The substance of this transaction is that
the 'seller' continues to control the asset, so it remains in the statement of financial position. The
obligation to redeem for cash is recorded as a liability.
However, Lehman Brothers transferred assets worth 105 per cent of the cash it received in return.
Because of this, under the rules in US GAAP it was able to record the transaction as a sale on the
grounds that technically it had lost control of the assets and no longer owned them. Therefore the
cash received was recorded as an asset rather than a liability. The bank's liabilities were significantly
understated and it was able to mislead investors and lenders about its true financial position.

17 QUALITATIVE CHARACTERISTICS OF FINANCIAL

INFORMATION

Section overview
 Qualitative characteristics are the attributes that make the information provided in financial
statements useful to users.
 The two fundamental qualitative characteristics are: relevance and faithful representation.
 The four enhancing qualitative characteristics are: comparability, verifiability, timeliness and
understandability.

The IASB's Conceptual Framework for Financial Reporting sets out and explains the qualitative
characteristics of useful financial information.
There are two : and .
Information must be possess these characteristics in order to be useful.
There are four : and
. These qualities enhance the usefulness of financial information.

17.1 RELEVANCE
Relevant financial information has or .

Definition

Relevant financial information is capable of making a difference in the decisions made by

users. (Conceptual Framework)

Information on financial position and performance is often used to future position and
performance and other things of interest to the user, for example, likely dividend, wage rises. Financial
information is also used to (or change) users' past conclusions about an entity's financial
performance or financial position.
Information can have both predictive value and confirmatory value. For example, revenue for the
current year can be used to predict revenue for next year. Actual revenue for the current year can also
be compared with expected revenue that was predicted using last year's financial statements.

17.1.1 MATERIALITY
The relevance of information is affected by its .
 58 | THE FINANCIAL REPORTING ENVIRONMENT

Definition

. Information is material if omitting it or misstating it could influence decisions that users

make on the basis of financial information about a specific reporting entity. (Conceptual Framework)

The Conceptual Framework explains that materiality is entity-specific. It depends on the nature or size
(or both) of items taken in the context of an individual entity's financial report.
Information may be judged relevant simply because of its nature, even though the amounts involved
may be small in relation to the financial statements as a whole (for example, remuneration of
management). In other cases, both the nature and materiality of the information are important.
Materiality is not a primary qualitative characteristic itself because it is merely a threshold or cut-off
point.

17.2 FAITHFUL REPRESENTATION

To be useful, financial information must faithfully represent the economic events that it purports to
represent. The user must be able to depend on it being a .

Definitions

. A faithful representation is , and .

A depiction includes all the information necessary for a user to understand the
phenomenon being depicted, including all necessary descriptions and explanations.
A depiction is without bias in the selection or presentation of financial information. This means
that information must not be manipulated in any way in order to influence the decisions of users.
means there are no errors or omissions in the description of the phenomenon and no
errors made in the process by which the financial information was produced. It does not mean that no
inaccuracies can arise, particularly where estimates have to be made. (Conceptual Framework)

17.3 COMPARABILITY
Comparability is the qualitative characteristic that enables users to identify and understand similarities
in, and differences among, items. Information about a reporting entity is more useful if it can be
compared with similar information about other entities and with similar information about the same
entity for another period or another date.
The consistency of treatment is therefore important across like items over time, within the entity and
across all entities.
The is particularly important here. Users must be able to
distinguish between different accounting policies in order to be able to make a valid comparison of
similar items in the accounts of different entities.
Comparability is that is, items need not be identical in order to be
comparable. For information to be comparable, like things must look alike and different things must
look different, Comparability is not enhanced by making unlike items look alike. Therefore entities
should change accounting policies if they become inappropriate.
Corresponding information for should be shown to enable comparison over time.

17.4 VERIFIABILITY
Verifiability helps assure users that information faithfully represents the economic events it purports to
represent.
Verifiability means that different knowledgeable and independent observers could reach consensus
(not necessarily complete agreement) that a particular depiction is a faithful representation.
 FINANCIAL ACCOUNTING AND REPORTING | 59

17.5 TIMELINESS
Timeliness means having information available to users in time to be capable of influencing their
decisions.
Generally, the older the information is, the less useful it is. However, older financial information may
still be useful for identifying and assessing trends (for example, growth in profits over a number of
years).

17.6 UNDERSTANDABILITY
Classifying, characterising and presenting information clearly and concisely makes it .
Some information is inherently complex and difficult to understand. Excluding this information from
the financial statements would make them more understandable, but they would also be incomplete
and potentially misleading.
Financial reports are prepared for users who have a reasonable knowledge of business and economic
activities and who review and analyse the information diligently. Users may sometimes need to seek
help from an adviser in order to understand information about complex economic events.

17.7 APPLYING THE QUALITATIVE CHARACTERISTICS

Information must be both relevant and faithfully represented if it is to be useful. In practice, an entity
must often find a balance between the two, with the aim of presenting the most relevant information
that can be faithfully represented.
A faithful representation, by itself, does not necessarily result in useful information. Suppose that an
entity receives a government grant to purchase an asset. The asset has no cost to the entity and
therefore is not recognised in the statement of financial position. This is a faithful representation of the
transaction, but users of the financial statements are not aware that the entity has the asset. They have
been deprived of useful and relevant information.
The same principle applies to the enhancing qualitative characteristics. Sometimes, one characteristic
may have to be diminished in order to maximise another. For example, applying a new standard may
reduce comparability in the short term, but may improve relevance or faithful representation in the
longer term.

17.8 THE COST CONSTRAINT ON USEFUL FINANCIAL REPORTING

Cost is a pervasive constraint on the information that can be provided by financial reporting. The
Conceptual Framework explains that it is important that the costs of reporting financial information
are justified by the benefits.
The IASB takes this into account when developing standards. It considers costs and benefits in relation
to financial reporting generally, not just in relation to individual entities. Different reporting
requirements for different reporting entities may be appropriate in some circumstances. For example,
the IASB has recently developed a special standard for small and medium sized entities.
 60 | THE FINANCIAL REPORTING ENVIRONMENT

18 INTERNATIONAL FINANCIAL REPORTING

STANDARDS

Section overview
 There are currently 16 IFRS in issue, as well as several International Accounting Standards
(IAS).
 IFRS are having a growing influence on national accounting requirements and practices.
 Where a company has to change from a national GAAP to IFRS, it has to deal with a
number of practical issues.

18.1 STANDARDS CURRENTLY IN ISSUE

The current list of International Accounting Standards and International Financial Reporting Standards
is as follows:

IAS 1 (revised) Presentation of Financial Statements Jun 2011

IAS 2 Inventories Dec 2003
IAS 7 Statement of Cash Flows Dec 1992
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors Dec 2003
IAS 10 Events after the Reporting Period Dec 2003
IAS 12 Income Taxes Nov 2000
IAS 16 Property, Plant and Equipment Dec 2003
IAS 17 Leases Dec 2003
IAS 19 Employee Benefits
(revised) Jun 2011
IAS 20 Accounting for Government Grants and Disclosure of Government Assistance Jan 1995
IAS 21 The Effects of Changes in Foreign Exchange Rates Dec 2003
IAS 23 Borrowing Costs
(revised) Jan 2008
IAS 24 Related Party Disclosures
(revised) Nov 2009
IAS 26 Accounting and Reporting by Retirement Benefit Plans Jan 1995
IAS 27 Consolidated and Separate Financial Statements
(revised) May 2011
IAS 28 Investments in Associates and Joint Ventures
(revised) May 2011
IAS 29 Financial Reporting in Hyperinflationary Economies Jan 1995
IAS 32 Financial Instruments: Presentation Dec 2003
IAS 33 Earnings per Share Dec 2003
IAS 34 Interim Financial Reporting Feb 1998
IAS 36 Impairment of Assets Mar 2004
IAS 37 Provisions, Contingent Liabilities and Contingent Assets Sep 1998
IAS 38 Intangible Assets Mar 2004
IAS 40 Investment Property Dec 2003
IAS 41 Agriculture Feb 2001
 FINANCIAL ACCOUNTING AND REPORTING | 61

IFRS 1 (revised) First time Adoption of International Financial Reporting Nov 2008 1 Jul 2009
Standards
IFRS 2 Share-based Payment Feb 2004 1 Jan 2005
IFRS 3 (revised) Business Combinations Jan 2008 1 Jul 2009
IFRS 4 Insurance Contracts Mar 2004 1 Jan 2005
IFRS 5 Non-current Assets Held for Sale and Discontinued Operations Mar 2004 1 Jan 2005
IFRS 6 Exploration for and Evaluation of Mineral Resources Dec 2004 1 Jan 2006
IFRS 7 Financial Instruments: Disclosures Aug 2005 1 Jan 2007
IFRS 8 Operating Segments Nov 2006 1 Jan 2009
IFRS 9 Financial Instruments Nov 2013 1 Jan 2018
IFRS 10 Consolidated Financial Statements May 2011 1 Jan 2013
IFRS 11 Joint Arrangements May 2011 1 Jan 2013
IFRS 12 Disclosure of Interests in Other Entities May 2011 1 Jan 2013
IFRS 13 Fair Value Measurement May 2011 1 Jan 2013
IFRS 14 Regulatory Deferral Accounts Jan 2014 1 Jan 2016
IFRS 15 Revenue from Contracts with Customers May 2014 1 Jan 2018
IFRS 16 Leases Jan 2016 1 Jan 2019
IFRS 17 Insurance Contracts May 2017 1 Jan 2021
IFRS for SMEs International Financial Reporting Standard for Small and Jul 2009
Medium sized Entities

18.2 SCOPE AND APPLICATION OF IFRS

18.2.1 SCOPE
Any limitation of the applicability of a specific IFRS is made clear within that standard. IFRS are
. An item is immaterial if its omission or misstatement
would not influence decisions that users of financial statements make. Each individual IFRS lays out its
scope at the beginning of the standard.

18.2.2 APPLICATION
Within each individual country govern, to varying degrees, the issue of financial
statements. These local regulations include accounting standards issued by the national regulatory
bodies and/or professional accountancy bodies in the country concerned.

18.3 ALTERNATIVE TREATMENTS

Many of the old standards permitted two accounting treatments for like transactions or events. One
treatment was designated as the (effectively the ) and the
other was known as the . This is no longer the case. However, some standards do
still allow more than one policy – for instance, IAS 16 allows property, plant and equipment to be carried at
cost or revalued amount.

18.4 INTERPRETATION OF IFRS

The IFRS Interpretations Committee (as discussed earlier in this module) has the responsibility for
issuing additional guidance on the application of an accounting standard where unsatisfactory or
conflicting interpretations exist. The documents issued are called IFRICs. As at October 2016, there
are 21 IFRICs in issue (of which 13 are still in force), together with 32 SICs (of which 27 have been
superseded) which were issued by the IFRS Interpretations Committee's predecessor, the Standing
Interpretations Committee.
 62 | THE FINANCIAL REPORTING ENVIRONMENT

The IFRS Interpretations Committee may also suggest IASB agenda items if there are financial
reporting issues that are not specifically covered by an IFRS.

18.5 FAIR PRESENTATION OVERRIDE

There may be (very rare) circumstances when management decides that compliance with a
requirement of an IFRS would be misleading. is therefore required to
achieve a fair presentation. IAS 1 Presentation of Financial Statements states that the following should
be disclosed in such an event:
 management confirmation that the financial statements fairly present the entity's financial position,
performance and cash flows;
 a statement that all IFRS have been complied with except departure from one IFRS to achieve a fair
presentation;
 details of the nature of the departure, why the IFRS treatment would be misleading, and the
treatment adopted; or
 financial impact of the departure.
This is sometimes referred to as the or the . Not
all jurisdictions allow the use of the 'true and fair' override. For example, in Australia, preparers of
financial statements are not permitted to depart from any of the requirements of accounting
standards (see section 6.10). Instead, the financial statements must disclose additional information.

18.6 EXTREME CASE DISCLOSURES

In very rare circumstances, management may conclude that compliance with a requirement in a
Standard or Interpretation may be so that it would of financial
statements set out in the Conceptual Framework, but the relevant regulatory framework prohibits
departure from the requirements. IAS 1 states that in such cases the entity needs to reduce the
perceived misleading aspects of compliance by :
 the title of the Standard, the nature of the requirement and the reason why management has
reached its conclusion; and
 for each period, the adjustment to each item in the financial statements that would be necessary to
achieve fair presentation.

18.7 WORLDWIDE EFFECT OF IFRS AND THE IASB

The IASB, and before it the IASC, has now been in existence for around 40 years, and it is worthwhile
considering the effect it has had in that time.
As far as is concerned, the consolidated financial statements of many of Europe's top
multinationals are now prepared in conformity with national requirements, European Commission (EC)
directives and IFRS. Furthermore, IFRS are having a growing influence on national accounting
requirements and practices. Many of these developments have been given added impetus by the
internationalisation of capital markets.
has wholly adopted IFRS and issues Australian Equivalent International Financial Reporting
Standards (AIFRS). The AASB adopted IFRS for annual reporting periods for companies from
1 January 2005. This means that all general financial purpose statements prepared by for-profit
entities prepared in accordance with AASB are also in accordance with IFRS.
In 2006, officially released a new set of Chinese Accounting Standards (CASs) which are
substantially converged with IFRSs, and reaffirmed its commitment to international convergence.
In 2005, the IASB and the Accounting Standards Board of (ASBJ) announced a joint project to
reduce differences between IFRSs and Japanese accounting standards. Since 2010, Japanese listed
companies meeting certain criteria have been permitted to use IFRSs as designated by The Financial
Services Agency of Japan. Consultation is also underway on the use of IFRSs in Japan.
 FINANCIAL ACCOUNTING AND REPORTING | 63

Until recently, the was one of the few countries in which IFRS financial statements were not
accepted. However, over the last 10 years the US authorities have moved significantly closer to
recognising IFRS, although it is unlikely that the US will adopt IFRSs in the near future. Convergence of
IFRS and US GAAP was discussed earlier when we introduced the Norwalk Agreement, and is
discussed in more detail in the following section.

18.8 EFFECT OF HARMONISATION ON COMPANIES

There are two main ways in which an individual country can harmonise its national GAAP with IFRS. It
can require some or all entities (usually listed companies) to comply with IFRS from a particular date.
Alternatively, it can converge its domestic standards with IFRS over a period of time, typically in
stages. Obviously, the effect on individual companies is less dramatic and easier to manage if
countries choose the second of these routes to harmonisation.
Where a company has to change from a national GAAP to IFRS on a particular date it has to deal with
a number of practical issues. Typically, the main issues are as follows:
 Management, internal accounts staff and auditors need to be fully trained in IFRS. While there may
be broad similarities between domestic standards and IFRS, there are frequently numerous
differences in the detail.
 Accounting systems and information systems may need to be upgraded to deal with more
complex or different reporting requirements.
 It is important to communicate with shareholders (particularly investors, lenders and their advisors)
to prepare them for the possible effect of the change on the entity's reported results and financial
position.
 The change to IFRS affects reported profits and net assets. Management remuneration may
depend on a certain level of profits or on increases in profits. Debt covenants (agreements with
lenders) may depend on a company maintaining a key level of assets to liabilities, or debt to
equity. Remuneration schemes and debt covenants may need to be re-negotiated.
 IFRS disclosure requirements may be far more onerous than those of national GAAP. Preparers
need to make sure that they have all the necessary information, bearing in mind that they will need
to present at least one set of comparative figures under IFRS, as well as the figures for the current
year.
 It may still be necessary to prepare accounts under national GAAP for the tax authorities.
A 2009 AASB publication IFRS Adoption in Australia summarised the outcomes of the change to IFRS
from 2005. The benefits have been:
 Australian entities' financial reports are more readily understood world wide;
 there are synergies in the preparation, audit and analysis of Australian financial reports for entities
that are part of a multinational group; and
 improved reporting of financial instruments (an area in which IFRS was more comprehensive than
Australian GAAP).
The disadvantages have been:
 the initial costs of adoption, particularly for banks and insurers in implementing the standards on
financial instruments;
 the pace of change: companies have had to deal with numerous amendments to IFRS that are
often driven by issues that are not a concern in Australia; and
 accounting and reporting issues that are important to Australian companies (for example, for
extractive industries) are not a priority for the IASB.
64 | THE FINANCIAL REPORTING ENVIRONMENT

Case study: Reporting under IFRS

When companies adopt IFRS for the first time, they are required to include a reconciliation between
profit after tax as previously reported and profit after tax under IFRS.
An extract from the financial statements of a retail group for the year ended 31 December 2005 (the
first full year of applying IFRS) is shown below. The reconciliation statement is for the year ended
31 December 2004 (the previous year).
(b) Reconciliation of profit after tax between AGAAP (Australian Generally Accepted Accounting
Principles) and AIFRS.

Profit after tax attributed to Members as previously reported under 832.9 347.7
AGAAP
Investment property revaluations (1) 2 298.1 –
Minority interest property revaluations (1) (141.2) –
Investment property revaluations attributable to equity accounted
associates (1) 462.2 –
Deferred tax charge (1) (358.4) (29.0)
Goodwill on acquisitions (due to the recognition of deferred tax
liabilities) written off (1) (460.0) –
Other AIFRS adjustments (3.2) (0.2)
Profit after tax attributable to members under AIFRS 2 630.4 318.5
AASB 10 'Investment Property' requires revaluation increment/decrement to be recognised through
(1)

the income statement. Under AGAAP revaluation movements were recognised in the asset revaluation
reserve.
Profit for the year is significantly higher under IFRS than under Australian GAAP (AGAAP). This is
because of the effect of IFRS on the group's investment properties (see the note to the statement). At
this time, property prices were steadily rising.
Below is shown another reconciliation statement, this time from the financial statements of a
telecommunications and media company for the year ended 30 June 2005 (this company's first full
year of reporting under IFRS was the year to 30 June 2006). This company is in a different business
from the retail group and the effect of adopting IFRS is not as pronounced. There is no one significant
item, but a number of differences and the overall effect is to reduce profit for the year by $129 million
(or by just under 3 per cent).
 FINANCIAL ACCOUNTING AND REPORTING | 65

19 DEVELOPMENTS IN INTERNATIONAL
HARMONISATION

Section overview
 Although the IASB has faced criticism and political pressures, there is broad general
support for its overall objective of implementing a single set of high quality, global financial
reporting standards.

Arguably, the development of high quality International Financial Reporting Standards has been a
major factor in making international harmonisation possible. International standards have to be
perceived as at least as good as, or preferably better than, the national GAAP that they replace,
otherwise they will not be accepted by the world's major stock exchanges.
This section looks at the progress that has been made towards harmonisation and the obstacles that
still remain.
 66 | THE FINANCIAL REPORTING ENVIRONMENT

19.1 THE IASB AND IOSCO

The International Organisation of Securities Commissions (IOSCO) is the representative of the world's
securities markets' regulators. High quality information is vital for the operation of an efficient capital
market, and differences in the quality of the accounting policies and their enforcement between
countries leads to inefficiencies between markets. IOSCO has been active in encouraging and
promoting the improvement and quality of IFRS over the last 15 years. This commitment was
evidenced by the agreement between the International Accounting Standards Committee (IASC) (the
predecessor of the IASB) and IOSCO to work on a program of 'core standards' which could be used
by publicly listed entities when offering securities in foreign jurisdictions.
The 'core standards' project resulted in 15 new or revised IFRS and was completed in 1999. IOSCO
spent a year reviewing the results of the project and released a report in May 2000 which
recommended to all its members that they allow multinational issuers to use IFRS, as supplemented
by reconciliation, disclosure and interpretation where necessary to address outstanding substantive
issues at a national or regional level.
IASB staff and IOSCO continue to work together to resolve outstanding issues and to identify areas
where new IASB standards are needed. In June 2016 the IASB and IOSCO strengthened their
cooperation by publishing a joint Statement of Protocols, the aim being the development and
consistent application of international standards.

19.2 POLITICAL PROBLEMS

Any international body, whatever its purpose or activity, faces enormous political difficulties in
attempting to gain and the IASB is no exception to this. How can the IASB
reconcile the financial reporting situation between economies as diverse as third-world developing
countries and sophisticated first-world industrial powers?
are suspicious of the IASB, believing it to be dominated by the This arises
because acceptance by the US listing authority, the Securities and Exchange Commission (SEC), of
IFRS has been seen as a major hurdle to be overcome. For all practical purposes it is the American
market which must be persuaded to accept IFRS and we discussed this earlier in this module when we
briefly looked at the Norwalk Agreement. Developing countries have been catered for to some extent
by the issue of a Standard on , which is generally of much more relevance to such
countries.
There are also tensions between the of financial reporting and the .
The UK/US model is based around investor reporting, whereas the European model is mainly
concerned with tax rules, so shareholder reporting has a much lower priority.
Although the EU countries have now adopted IFRS for the consolidated financial statements of listed
entities, the Regulation actually requires listed companies to adopt the standards and Interpretations
that have been Many
have feared that in practice this might lead to EFRAG effectively becoming a
and that eventually Europe might . This has
.
The of 2008 intensified the above problems. Because IFRS requires most
financial assets to be measured at fair value, entities had to record huge losses on remeasurement
when share prices fell. Many argued that by requiring the use
of (sometimes called 'mark to market' accounting). Some politicians, particularly within
Europe, began to press the IASB to amend its financial instruments standards urgently so that
companies would not have to recognise changes in the fair value of financial instruments in profit or
loss. The IASB responded by accelerating its project to develop a new standard on financial
instruments and this led to the issuing of IFRS 9, which has an effective adoption date of 1 January 2018,
but has not retreated from its basic position, that is, that most financial assets should be measured at
fair value.
 FINANCIAL ACCOUNTING AND REPORTING | 67

Many also voiced of the IASB and the IFRS Foundation that:
 it was not publicly accountable;
 its operating procedures were not sufficiently transparent and did not allow enough consultation;
and
 it continued to be dominated by US interests and has prioritised convergence to US GAAP at the
expense of other projects.
The IASB has responded to these criticisms by making some changes in its constitution and operating
procedures. These include the following:
 A has been set up to provide a
. The role of the Monitoring Board was described earlier in this module.
 The has changed. Originally, the IASB board had 14 members, of
which 12 were full time and 2 were part time. Although most developed countries were
represented, in practice over half the members came from North America. The IASB now has 12
members. As before, the members are appointed on the basis of their experience and technical
expertise and are selected so that there is a mix of auditors, preparers of financial statements,
users of financial statements and academics. Currently, there are 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.
 Three-yearly public consultations on the IASB's technical agenda have been introduced. The most
recent of these consultations took place in 2015 and the results were announced on
2 November 2016. The IASB has taken account of these results in drawing up its current work
program.
 A provision for accelerated due process has been introduced for use in exceptional circumstances.
Despite the criticisms, there is still broad general support for the IASB's overall objective of
implementing a single set of high quality, global financial reporting standards.

19.3 THE EUROPEAN COMMISSION (EC) REGULATION

As we have already seen, the EC regulations form one part of a broader program for the
harmonisation of company law in member states. The Commission is uniquely the only organisation to
produce standards of accounting practice that are legally enforceable, in the form of
directives that must be included in the national legislation of member states. The directives have been
criticised as they might become constraints on the application of world-wide standards and bring
accounting standardisation and harmonisation into the political arena.
The EC adopted a regulation stating that
The implications of this are far reaching.
Many commentators believe that, in the light of the above, it is only a matter of time before national
standard-setting bodies are, in effect, replaced by the IASB and national standards fall into disuse.
However, national standards were designed for the national environment, which may include small
companies, the not-for-profit private sector and/or the public sector. Moreover, the IASB will need
input and expertise from valued national standard-setters.

19.4 CONVERGENCE WITH US GAAP

Since 2002 there have been a variety of attempts to increase convergence of International and US
accounting standards. Some standards have been issued jointly by the IASB and FASB, and since 2007
Companies listed on US stock exchanges but filing financial statements under IFRSs have not been
required to prepare a reconciliation to US GAAP. However pressure within the US accounting
community means that there is unlikely to be a move to IFRSs in the near future.
As discussed earlier in this module, in October 2004 the IASB and FASB agreed to develop a
which would be a significant step towards harmonisation of future standards.
 68 | THE FINANCIAL REPORTING ENVIRONMENT

Several chapters were released, but the remainder of the new Conceptual Framework will be
developed by the IASB alone.

19.5 DIALOGUE WITH OTHER KEY STANDARD-SETTERS

The IASB maintains a policy of dialogue with other key standard-setters around the world, in the
interest of harmonising standards across the globe.
National standard-setters are often involved in the development of Discussion Papers and Exposure
Drafts on new areas. To ensure international representation, both the members of the IASB and the
Trustees of the IFRS Foundation are to be taken from a broad geographical range which is specified:
six from Asia/Oceania; six from Europe; six from North America; one from Africa; one from South
America; and two from the rest of the world.
In addition, in 2013 the IFRS Foundation set up a new body, the Accounting Standards Advisory
Forum (ASAF). This consists of national accounting standard setters and regional bodies with an
interest in financial reporting. The purpose of the group is to provide technical advice and feedback to
the IASB. The 12 members of the ASAF are chosen to ensure a broad geographical representation
and balance of the major economic regions of the world and include the US FASB, the Australian
Accounting Standards Board (AASB) and the UK Financial Reporting Council, as well as the standard-
setting bodies from China and Japan and the Asian-Oceanian Standard Setters Group. The IFRS
Trustees review membership of ASAF every two years.

19.6 THE SITUATION TODAY AND IN THE FUTURE

Many organisations committed to global harmonisation have done a great deal of work towards this
goal. It is the case at present, however, that some disagreements still exist between countries and
organisations about the way forward. One of the major inconsistencies is between the reporting
requirements in developed countries and those in non-developed countries. It will be some time
before these difficulties can be overcome. The IASB is likely to be the lead body in attempting to do
so, as discussed above.
 FINANCIAL ACCOUNTING AND REPORTING | 69

KEY MODULE POINTS 3

 A principles-based system works within a set of laid down principles. A rules-based system
regulates for issues as they arise. Both of these have advantages and disadvantages.
 There are arguments for and against having accounting standards.
 is an underlying assumption in preparing financial statements.
 Financial information (other than information about cash flows) should be prepared on the
basis.
 Qualitative characteristics are the attributes that make the information provided in financial
statements useful to users.
 The two fundamental qualitative characteristics are: and .
 The four enhancing qualitative characteristics are:
.
 Although the IASB has faced criticism and political pressures, there is broad general support for its
overall objective of implementing a single set of high quality, global financial reporting standards.
70 | THE FINANCIAL REPORTING ENVIRONMENT

QUICK REVISION QUESTIONS 3

1 Which of the following is an advantage of a principles based system of accounting standard

setting?
A It always provides the answers.
B It discourages creative accounting.
C It results in greater comparability of financial statements.
D It needs to be supported by illustrative examples and interpretations.

2 Which of the following statements are correct?

I. Application of IFRS is presumed to result in financial statements that achieve a fair presentation.
II. Under IFRS, all published financial statements are required to present fairly the financial
position and financial performance of an entity.
A I only
B II only
C both I and II
D neither I nor II

3 Which of the following statements represents a disadvantage of the use of accounting standards?
A Standards are a less rigid alternative to legislation.
B Standards may tend towards rigidity in applying the rules.
C Standards oblige companies to disclose their accounting policies.
D Standards reduce variations in methods used to produce accounts.

4 According to the Conceptual Framework, which of the following is the

relating to financial statements?
A The information is free from material error or bias.
B The accounts have been prepared on an accruals basis.
C The business is expected to continue in operation for the foreseeable future.
D Users are assumed to have sufficient knowledge to be able to understand the financial
statements.

5 There are four enhancing qualitative characteristics of useful financial information. What are those
characteristics?
A going concern, accruals, completeness, verifiability
B comparability, timeliness, verifiability, understandability
C substance over form, neutrality, going concern, accruals
D comparability, understandability, completeness, neutrality

6 Listed below are some comments on accounting concepts and useful financial information:
I. Materiality means that only items having a physical existence may be recognised as assets.
II. A faithful representation of financial information can never include amounts based on estimates.
III. Financial information prepared using accrual accounting provides a better basis for assessing an
entity's performance than information based only on cash flows.

Which, if any, of these comments is correct, according to the IASB's Conceptual Framework for
Financial Reporting?
A I only
B II only
C III only
D none of the above
 FINANCIAL ACCOUNTING AND REPORTING | 71

7 What is the accounting concept called that requires income and expenses to be matched in the
period in which they occur, rather than when the cash is received or paid?
A accruals
B neutrality
C materiality
D faithful representation

8 How many IFRS have been published by the IASB (excluding the IFRS for SMEs)?
A 17
B 29
C 41
D 43

9 Which of the following is a benefit of harmonisation?

A ability of investors to compare cross border financial statements
B increased training of staff to deal with new accounting standards
C amendment of tax systems in different countries to align with accounting requirements
D different countries have different legal systems for accounting which need to be amended

10 With which accounting body has the IASB carried out a joint project to develop several common
accounting standards?
A the OECD
B the Standards Advisory Council
C the Financial Accounting Standards Board
D the Australian Accounting Standards Board
 72 | THE FINANCIAL REPORTING ENVIRONMENT

20 THE ELEMENTS OF FINANCIAL STATEMENTS

Section overview
 Transactions and other events are grouped together in broad and in this way their
financial effects are shown in the financial statements. These broad classes are the
of financial statements.

20.1 SUBJECT OUTLINE

Earlier in this module, we discussed the principles of the IASB's Conceptual Framework for Financial
Reporting. This section looks at some of the detail within the Conceptual Framework and examines
the definitions of the elements of financial statements.
The Conceptual Framework sets out these elements as follows:

Elements of financial
statements

Measurement of Measurement of
financial position in performance in the
the statement of statement of profit or
financial position loss and other
comprehensive income

• Assets • Income
• Liabilities • Expenses
• Equity

A process of then takes place for presentation in the financial statements, for
example, assets are classified by their nature or function in the business to show information in the
best way for users to make economic decisions.

20.2 FINANCIAL POSITION

We need to define the three terms listed under this heading above.

Definitions

. A resource controlled by an entity as a result of past events and from which future economic
benefits are expected to flow to the entity.

. A present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.

. The residual interest in the assets of the entity after deducting all its liabilities.
(Conceptual Framework)
 FINANCIAL ACCOUNTING AND REPORTING | 73

These definitions are important, but they do not cover the of any of these
items, which are discussed in the next section of this module. This means that the definitions may
include items which would not actually be recognised in the statement of financial position because
they fail to satisfy recognition criteria particularly, as we will see below, the
to or from the business.
Whether an item satisfies any of the definitions above will depend on the
of the transaction, not merely its legal form as discussed earlier.

20.3 ASSETS
We can look in more detail at the components of the definitions given above.

Definition

. The potential to contribute, directly or indirectly, to the flow of cash and

cash equivalents to the entity. The potential may be a productive one that is part of the operating
activities of the entity. It may also take the form of convertibility into cash or cash equivalents or a
capability to reduce cash outflows, such as when an alternative manufacturing process lowers the cost
of production. (Conceptual Framework)

Assets are usually employed to produce goods or services for customers; customers will then pay for
these, so resulting in future economic benefit.
The existence of an asset, particularly in terms of , is not reliant on:
(a) (hence patents and copyrights are assets); nor
(b) (hence leases can give rise to assets).
Transactions or events give rise to assets; those expected to occur in the future do not in
themselves give rise to assets. For example, an intention to purchase a non-current asset does not, in
itself, meet the definition of an asset.

20.4 LIABILITIES
Again we can look more closely at some aspects of the definition. An essential characteristic of a
liability is that the entity has a .

Definition

. A duty or responsibility to act or perform in a certain way. Obligations may be legally

enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise,
however, from normal business practice, custom and a desire to maintain good business relations or
act in an equitable manner. (Conceptual Framework)

It is important to distinguish between a present obligation and a . A management

decision to purchase assets in the future does not, in itself, give rise to a present obligation. An
obligation is something that .
of a present obligation will involve the entity giving up resources embodying economic
benefits in order to satisfy the claim of the other party. This may be done in various ways, not just by
payment of cash.
Liabilities must arise from . For example, in the recognition of future
rebates to customers based on annual purchases, the sale of goods in the past is the transaction that
gives rise to the liability.

20.4.1 PROVISIONS
Companies may include provisions, for example, for legal damages or warranty obligations, in their
financial statements. Is a provision a liability?
 74 | THE FINANCIAL REPORTING ENVIRONMENT

Definition

A present obligation which satisfies the rest of the definition of a liability, even if the
amount of the obligation has to be estimated. (Conceptual Framework)

Question 13: Asset or liability?

Consider the following situations. In each case, does the company have an asset or liability within the
definitions given by the Conceptual Framework? Give reasons for your answer.
(a) Pat Co. has purchased a patent for $20 000. The patent gives the company sole use of a particular
manufacturing process which will save $3000 a year for the next 5 years.
(b) Baldwin Co. paid a mechanic $10 000 to set up a car repair shop, on condition that priority
treatment is given to cars from the company's fleet.
(c) Deals on Wheels Co. announces that it will pay all of its staff a bonus.
(The answer is at the end of the module.)

20.5 EQUITY
Equity is defined above as a , but it may be sub-classified in the statement of financial position
into different equity reserves. The amount shown for equity depends on the
This is discussed in more detail later in this module.

20.6 FINANCIAL PERFORMANCE

Profit is used as a , or as a basis for other measures (e.g. earnings per share).
It depends directly on the measurement of income and expenses, which in turn depend (in part) on
the concepts of capital (the amount invested in a business by its owners) and capital maintenance
adopted (see Module 2).
The elements of income and expenses are therefore defined.

Definitions

. Increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than those
relating to contributions from equity participants.
. Decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurring of liabilities that result in decreases in equity, other than those
relating to distributions to equity participants. (Conceptual Framework)

Income and expenses can be in the financial statements to provide

information relevant for economic decision-making. For example, a distinction is made between
income and expenses which relate to continuing operations and those which do not.

20.7 INCOME
Both and are included in the definition of income. arises in the course of
ordinary activities of an entity.

Definition

. Increases in economic benefits. As such they are no different in nature from revenue.
(Conceptual Framework)
 FINANCIAL ACCOUNTING AND REPORTING | 75

Gains include those arising on the disposal of non-current assets. The definition of income also
includes , for example, on revaluation of marketable securities. These are gains which
have not yet been realised because the securities have not yet been sold at the increased price.

20.8 EXPENSES
As with income, the definition of includes losses as well as those expenses that arise in the
course of ordinary activities of an entity.

Definition
. Decreases in economic benefits. As such they are no different in nature from other expenses.
(Conceptual Framework)

Losses will include those arising on the disposal of non-current assets. The definition of expenses will
also include , for example, downward revaluation of property, unrealised because
the property has not been sold at the reduced value.

20.9 CAPITAL MAINTENANCE ADJUSTMENTS

Definition

. The revaluation or restatement of assets and liabilities gives rise

to increases or decreases in equity. (Conceptual Framework)

IFRSs allow or require certain assets to be measured at fair value in the financial statements. Such
assets are remeasured periodically in accordance with the requirements of relevant IFRS, to ensure
that an up to date fair value is reflected.
This periodic revaluation, or restatement, of an asset's carrying amount may be either upwards or
downwards, so resulting in either a gain (income) or a loss (expense).
The gain or loss is in an entity's profit or loss for the year under certain concepts of
capital maintenance. Instead it is shown as 'other comprehensive income'. Other comprehensive
income includes items of income or expense which are not permitted to be included in profit or loss
for the year, but which do meet the definition of income and expenses and result in an increase or
decrease in equity.

21 RECOGNITION OF THE ELEMENTS OF FINANCIAL

STATEMENTS

Section overview
 Items which meet the definition of assets or liabilities may still not be recognised in financial
statements because they must also meet certain .

Definition

. The process of incorporating into the statement of financial position or statement of

profit or loss and other comprehensive income an item that meets the definition of an element and
satisfies the following criteria for recognition:
 it is probable that any future economic benefit associated with the item will flow to or from the
entity; and
 the item has a cost or value that can be measured with reliability. (Conceptual Framework)
 76 | THE FINANCIAL REPORTING ENVIRONMENT

Regard must also be given to as defined in the Conceptual Framework.

Definition

. Information is material if omitting it or misstating it could influence decisions that users

make on the basis of financial information about a specific reporting entity. (Conceptual Framework)

21.1 PROBABILITY OF FUTURE ECONOMIC BENEFITS

Probability here means the that the future economic benefits associated with
an item will flow to or from the entity. This must be judged on the basis of the
and the when the financial statements are prepared.

21.2 RELIABILITY OF MEASUREMENT

The cost or value of an item, in many cases, . The Conceptual Framework states,
however, that the use of reasonable estimates is an essential part of the preparation of financial
statements and does not undermine their reliability. Where no reasonable estimate can be made, the
item should not be recognised, although its existence should be disclosed in the notes, or other
explanatory material.
Items may still qualify for recognition due to changes in circumstances or subsequent
events.

21.3 RECOGNITION OF ITEMS

We can summarise the recognition criteria for assets, liabilities, income and expenses, based on the
definition of recognition given above.

The statement of financial It is probable that the future economic benefits will flow to the
position entity and the asset has a cost or value that can be measured
reliably.
The statement of financial It is probable that an outflow of resources embodying
position economic benefits will result from the settlement of a present
obligation and the amount at which the settlement will take
place can be measured reliably.
The statement of profit or loss An increase in future economic benefits related to an increase
and other comprehensive in an asset or a decrease of a liability has arisen that can be
income measured reliably, other than those relating to contributions
from equity participants
The statement of profit or loss A decrease in future economic benefits related to a decrease
and other comprehensive in an asset or an increase of a liability has arisen that can be
income measured reliably, other than those relating to distributions to
equity participants

22 APPLYING THE RECOGNITION CRITERIA

Section overview
 The Conceptual Framework for Financial Reporting sets out criteria that should be applied
in determining whether to recognise assets, liabilities, equity, income or expenses in the
financial statements.
 FINANCIAL ACCOUNTING AND REPORTING | 77

22.1 ASSETS
The Conceptual Framework explains that an asset is not recognised in the statement of financial
position when expenditure has been incurred but it is considered not probable that economic
benefits will flow to the entity beyond the current accounting period. Instead, an expense is
recognised.
Consider the case of advertising expenditure. The company incurs the cost of having its products and
services advertised because management believes that increased sales revenue will result. It could be
argued that the advertising meets the definition of an asset: it is a resource controlled by the entity as
the result of a past transaction (the contract with the agency and the payment of the fee) and
economic benefit is expected to flow to the entity as a result (in the form of increased sales revenue).
But the cost of the advertising cannot be capitalised (recognised as an asset), because it fails at least
one and probably both of the recognition criteria:
 It is certainly possible that the entity will obtain economic benefit from the expenditure in a future
period, but it would normally be quite difficult to argue that an increase in revenue is probable.
Even if there is a pattern of increased sales following an advertising campaign, it would be very
difficult to prove that a certain number of customers bought a particular product or a service just
because they had seen an advert for it (although that may have been a factor, possibly a
subconscious one, in their decision).
 In the same way, it would be very difficult to prove that X amount of advertising expenditure
resulted in Y amount of additional sales revenue. Therefore the 'asset' does not have a cost that
can be measured reliably.
Question 14: Research and development expenditure

Below is an extract from the annual report of a retail group.

Expenditure on research activities, undertaken with the prospect of gaining new technical knowledge
and understanding, is recognised in the profit and loss as an expense as incurred.
Expenditure on development activities, whereby research findings are applied to a plan or design for
the production of new or substantially improved products and processes, is capitalised if the product
or process is technically and commercially feasible and the consolidated entity has sufficient resources
to complete development. The expenditure capitalised includes the cost of materials, direct labour
and an appropriate proportion of overheads.
Other development expenditure is recognised in the income statement as an expense as incurred.
Capitalised development expenditure is stated at cost less accumulated amortisation and impairment
losses.
Required
Explain the reasoning behind these accounting policies.
(The answer is at the end of the module.)

22.2 LIABILITIES
A liability is recognised in the statement of financial position when:
 it is that an outflow of resources embodying economic benefits will result from the
settlement of a present obligation; and
 the amount at which the liability will be settled can be .
There are two considerations here: deciding whether an outflow is probable; and estimating the
amount of the liability.
Consider a possible liability arising from a claim against a company. One of its customers has been
seriously injured, allegedly as the result of buying and using the company's products. For there to be a
 78 | THE FINANCIAL REPORTING ENVIRONMENT

liability, there must be a present obligation to pay damages as a result of a past event (the purchase
and use of the products). At the year-end, lawyers advise that there is approximately an 80 per cent
chance that the company will be found liable. It is that the company will have to
pay compensation, which will amount to between $50 000 and $100 000.
In this case, there is a liability and it meets the first of the recognition criteria: it is that there
will be an outflow of economic benefit. Because the lawyers have been able to determine a range of
possible outcomes the second recognition criteria is met: the amount of the liability
.
The company (a liability of uncertain timing or amount) for the best estimate
of the amount to settle the obligation.
Question 15: Legal claim
A customer is making a claim against a company. At the year-end, the company's lawyers advise that
there is approximately a 40 per cent chance that the company will be found liable and will have to pay
compensation.
Required
Explain how you would treat the claim in the financial statements for the period.
(The answer is at the end of the module.)

22.3 EQUITY
The Conceptual Framework defines equity as the residual interest in the assets of the entity after
deducting all its liabilities. This is a restatement of the basic accounting equation:
ASSETS – LIABILITIES = EQUITY
Equity consists of funds contributed by shareholders (share capital), retained earnings and other
reserves. Other reserves are normally appropriations of retained earnings.
Equity can be viewed as a type of liability: the amount owed to the equity shareholders (its owners).
However, there is a crucial difference between equity and liabilities. For there to be a liability there
must be an : an outflow of economic benefits that cannot realistically be avoided.
Many companies are financed by a mixture of equity and debt (borrowings).
 Debt finance is a of the company. The company will eventually have an
. In almost all cases, the company also has an on its
debt, regardless of the amount of the entity's profits or losses. There is normally reasonable
certainty about the amount that the lenders will receive and about when they will receive it.
 Share capital gives their holders the right to and (in
theory) to influence the policies adopted by management by exercising voting rights. They are
and uncertainties of the business. The return on their investment (in the form
of dividends) ; in a poor year they may receive nothing. If the
company is wound up, they may receive a share of its retained profits, but only after the lenders
and other creditors have been paid.
During the last thirty years there has been a growth in the number and complexity of types of financial
instrument. For legal reasons, some instruments are called shares although they have the
characteristics of debt. Preparers of financial statements should look at the economic substance of the
arrangement in order to decide whether a financial instrument is debt (a liability) or equity.
Question 16: Preference shares
A company has two classes of shares: ordinary shares and 6 per cent redeemable preference shares
which were issued at $1 each. Holders of the preference shares receive a dividend of 6 per cent of the
amount of their shareholding each year. For example, a shareholder who held 10 000 preference
shares would automatically receive a dividend of $600 each year, regardless of the company's
performance. The preference shares mature in five years' time: at that date the capital that the holders
have invested will be repaid to them.
 FINANCIAL ACCOUNTING AND REPORTING | 79

Required
Are the preference shares part of equity, or a liability? Explain your answer.
(The answer is at the end of the module.)

22.4 INCOME
The Conceptual Framework explains that income is recognised when:
 there has been an increase in future economic benefits related to an or a
; and
 this increase or decrease can be .
For example, when an entity makes a sale it recognises revenue and it also recognises an asset: cash
or an amount receivable that will eventually be converted into cash. This asset meets the recognition
criteria:
 it is probable that there will be an inflow of economic benefit (cash has either already been
received or will be received in the near future); and
 the amount can be reliably measured (it is normally a matter of fact and can be verified).
Similarly, when an entity recognises a gain on disposal of an asset it also recognises a net increase in
assets: tangible assets decrease, but cash increases by a greater amount.
Determining to recognise revenue can sometimes be a problem. Even a simple sales transaction
has several stages: the customer orders the goods; the goods are produced; the goods are delivered
to the customer; the customer is invoiced; and the cash is received. In theory, a company could argue
a case for recognising a sale at any of these stages, but generally accepted accounting practice is to
recognise the revenue when the goods are despatched to the customer. This is the in
the earnings cycle. At this point the company has its side of the sales contract with the
customer and has earned the right to payment. Control of the asset has been transferred to the
customer.
When it is a service that is sold, revenue is recognised as or when the service is performed. For
example, revenue from a magazine subscription is recognised over the period of the subscription.
In recent years, there have been several occasions on which companies have adopted controversial
accounting policies for revenue recognition (sometimes called 'aggressive earnings management').
These controversial policies have all involved recognising revenue before it has actually been earned.

Question 17: Airline

Below is an extract from the annual report of an international airline group:

Passenger, freight and tours and travel revenue is recognised when passengers or freight are
uplifted or when tours and travel air tickets and land content are utilised. Unused tickets are
recognised as revenue using estimates based on the terms and conditions of the ticket.
Required
Explain the reasoning behind this accounting policy by applying the recognition criteria in the
Conceptual Framework.
(The answer is at the end of the module.)

22.5 EXPENSES
The Conceptual Framework explains that expenses are recognised when:
(a) there has been a decrease in future economic benefits related to a or an
; and
(b) this increase or decrease can be .
 80 | THE FINANCIAL REPORTING ENVIRONMENT

For example, when an entity incurs office expenses such as light and heat, it recognises the expense
and it also recognises a liability: the amount payable to the supplier. This liability meets the
recognition criteria:
 it is probable that there will be an outflow of economic benefits (the entity must eventually pay the
amount it owes to the supplier); and
 the amount can be reliably measured (the amount payable will either have been invoiced or can be
estimated based on past experience).
Expenses are recognised in profit or loss on the basis of a direct association between the costs
incurred and the earning of specific items of income (the matching of costs and revenues). Applying
the matching concept should not result in the recognition of items in the statement of financial
position that do not meet the definition of assets or liabilities.
Where economic benefits are expected to arise over several accounting periods, expenses are
allocated to accounting periods in a systematic and rational way. For example, property, plant and
equipment is depreciated in order to match the expense of acquiring it to the income which it
generates. The expense is recognised in the accounting periods in which the economic benefits
associated with it are consumed.
When expenditure produces no future economic benefits an expense should be recognised
immediately in profit or loss. An expense is also recognised when a liability is incurred without the
recognition of an asset.

Question 18: Restoration costs

A mining company is legally obliged to restore the site and to rectify environmental damage after
each mine is closed. Typically, a mine is expected to operate for at least 20 years. Approximately 40
per cent of the eventual expense relates to the removal of mineshafts and the rectification of damage
that occurs when the mine is originally sunk, the remainder of the cost relates to damage that is
caused progressively as the minerals are extracted.
During the current reporting period the company has sunk a mineshaft but not yet commenced
extracting minerals.
According to the Conceptual Framework, how should this event be reported in the financial
statements for the current period and subsequent periods?
(The answer is at the end of the module.)

23 THE MAIN FINANCIAL STATEMENTS

Section overview
 The principal financial statements of a business are the
and the .

23.1 STATEMENT OF FINANCIAL POSITION

Definition

The is simply a of all the and all

the by a business as at a particular date. It is a snapshot of the financial position of the
business at a particular moment. Monetary amounts are attributed to each of the assets and liabilities.
 FINANCIAL ACCOUNTING AND REPORTING | 81

23.1.1 ASSETS
Examples of assets are factories, office buildings, warehouses, delivery vans, lorries, plant and
machinery, computer equipment, office furniture, amounts owing from customers (receivables), cash
and goods held in store awaiting sale to customers.
Some assets are held and used in operations for a long time. An office building is occupied by
administrative staff for years; similarly, a machine has a productive life of many years before it wears
out. These types of assets are called .
Other assets are held for only a short time. The owner of a newspaper shop, for example, has to sell
their newspapers on the same day that they get them. The more quickly a business can sell the goods
it has in store, the more profit it is likely to make; provided, of course, that the goods are sold at a
higher price than what it cost the business to acquire them. These are .

An entity must present and assets as separate classifications on the face of the
statement of financial position.

23.1.2 LIABILITIES
Examples of liabilities are amounts owed to a supplier for goods purchased on credit, amounts owed
to a bank (or other lender), a bank overdraft and amounts owed to tax authorities (e.g. in respect of
sales tax/GST).
Some liabilities are due to be paid fairly quickly for example, amounts payable to suppliers. Other
liabilities may take some years to repay (e.g. a bank loan).

The categorisation of current liabilities is very similar to that of current assets.

23.1.3 CAPITAL OR EQUITY

The amounts invested in a business by the owner, together with the retained profits of the business,
are amounts that the business owes to the owner. These are known as capital or equity. In a limited
liability company, capital introduced usually takes the form of shares. Equity may be thought of as the
owner's stake in the net assets of the business, but note that this would only be paid to the owner (less
liquidation costs) in the unlikely event of the business winding up.
 82 | THE FINANCIAL REPORTING ENVIRONMENT

23.1.4 FORM OF STATEMENT OF FINANCIAL POSITION

A statement of financial position may also be called a balance sheet. This name is appropriate
because assets will always be equal to liabilities plus equity. An example of a statement of financial
position for a company is shown below.
XYZ – STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER

Non-current assets
Property, plant and equipment 450 850 470 790
Goodwill 80 800 91 200
Other intangible assets 227 470 227 470
Financial assets 142 500 156 000
901 620 945 460
Current assets
Inventories 135 230 132 500
Trade receivables 91 600 110 800
Other current assets 25 650 12 540
Cash and cash equivalents 312 400 322 900
564 880 578 740
1 466 500 1 524 200

Share capital 650 000 600 000

Retained earnings 313 550 210 300
Other components of equity 10 200 21 200
973 750 831 500
Non-current liabilities
Long-term borrowings 120 000 160 000
Deferred tax 28 800 26 040
Long-term provisions 28 850 52 240
177 650 238 280
Current liabilities
Trade and other payables 115 100 187 620
Short-term borrowings 150 000 200 000
Current portion of long-term borrowings 10 000 20 000
Current tax payable 35 000 42 000
Short-term provisions 5 000 4 800
315 100 454 420
492 750 692 700
1 466 500 1 524 200
 FINANCIAL ACCOUNTING AND REPORTING | 83

Case study: Statement of financial position

The consolidated statement of financial position of Wesfarmers Ltd Group at 30 June 2012 is shown
below. This is presented in a different order from the illustration above, but notice that it still clearly
shows the three elements defined in the Conceptual Framework and the relationship between them:
ASSETS less LIABILITIES equals EQUITY. Many Australian companies present their statements of
financial position in the order used by Wesfarmers.
Notice also that it clearly analyses assets and liabilities between current items and non-current items.

Reproduced with permission from Wesfarmers Limited

 84 | THE FINANCIAL REPORTING ENVIRONMENT

23.2 STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE

INCOME
Definition

A is a of
and over a given period. The statement shows whether the business has had
more income than expenditure (a profit) or more expenditure than income (loss).

The statement of profit or loss and other comprehensive income shows, as the name suggests:
 profit or loss for the period; and
 other comprehensive income.
Together profit or loss and other comprehensive income give total comprehensive income and this
statement may also be referred to as the statement of comprehensive income.

23.2.1 INCOME AND EXPENSES

within the statement of profit or loss and other comprehensive income is the income earned
within a period. The are the costs of running the business for the same period.

23.2.2 OTHER COMPREHENSIVE INCOME

Certain items of income and expense do not form profit or loss for the year, and instead are
recognised as other comprehensive income. IAS 1 and other IFRSs specify the items which this applies
to, and requires that these are sub-classified according to whether they may be reclassified to profit or
loss at a future date.

23.2.3 FORM OF STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

The period chosen will depend on the purpose for which the statement is produced. The statement of
profit or loss and other comprehensive income which forms part of the published annual financial
statements of a will usually be for the period of a , commencing from
the date of the previous year's statements. On the other hand, might want to keep a
closer eye on a company's profitability by making up statements from a
management accounting perspective.
The statement of profit or loss and other comprehensive income may be shown as a single statement
or in two statements. The example below shows the 'single statement approach', starting with
revenue and ending with total comprehensive income. The alternative approach includes:
1. a statement of profit or loss, showing line items from revenue to profit or loss for the year; and
2. a second statement, the statement of comprehensive income, showing profit for the year (i.e. the
total from 1 above) and items of other comprehensive income to give total comprehensive income.

XYZ – STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE YEAR
ENDED 31 DECEMBER 20X7

Revenue 415 000 375 000

Cost of sales (245 000) (230 000)
Gross profit 170 000 145 000
Other income 17 767 16 400
Distribution costs (9 000) (8 700)
Administrative expenses (20 000) (21 000)
Other expenses (2 100) (1 200)
Finance costs (8 000) (7 500)
Profit before tax 148 667 123 000
Income tax expense (30 417) (27 000)
Profit for the year from continuing operations 118 250 96 000
Loss for the year from discontinued operations – (30 500)
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118 250 65 500

Remeasurement of financial assets (14 000) 20 000

Items that will not be reclassifofit or loss
Gains on property revaluation 3 000 8 000
Other comprehensive income for the year (11 000) 28 000
107 250 93 500

Case study: Statement of profit or loss and other comprehensive income

The statement profit or loss of Wesfarmers Ltd Group for the year ended 30 June 2012 is shown
below. Wesfarmers presents two separate statements of financial performance: an income statement
and a statement of comprehensive income. Only the income statement is shown here.
Notice that Wesfarmers analyses items of income and expenses according to their . The
illustration above analyses expenses by their . But the statement still clearly shows the two
elements: income and expenses.

for the year ended 30 June 2012 – Wesfarmers Ltd Group and its controlled entities

Reproduced with permission from Wesfarmers Limited

 86 | THE FINANCIAL REPORTING ENVIRONMENT

23.3 OTHER FINANCIAL STATEMENTS

The statement of financial position and the statement of profit or loss and other comprehensive
income form the basis of the financial statements of most businesses.
In Module 3, we will explain how to prepare a statement of financial position and a statement of profit
or loss and other comprehensive income for a limited liability company in accordance with IAS 1
Presentation of Financial Statements. Under IFRS, limited liability companies are also required to
prepare a and a as well as notes to the
financial statements.

23.3.1 STATEMENT OF CHANGES IN EQUITY

The statement of changes in equity shows the movements in the various components of equity (share
capital, retained earnings and other reserves) for a period. The purpose of the statement is to show
the transactions between the company and its owners. These consist of:
 total comprehensive income for the year, made up of the profit or loss for the year (changes in
retained earnings), plus other comprehensive income (items such as revaluation gains which are
not included in profit or loss, but recognised in a separate reserve within equity);
 contributions from owners: issues of shares; and
 distributions to owners: dividends paid.
An example of a simple statement of changes in equity is shown below.
XYZ – STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 20X7

600 000 210 300 21 200 831 500

Issue of share capital 50 000 – – 50 000

Dividends – (15 000) – (15 000)

Total comprehensive
income for the year – 118 250 (11 000) 107 250
650 000 313 550 10 200 973 750

The preparation of a statement of changes in equity is covered in Module 3.

23.3.2 STATEMENT OF CASH FLOWS

The statement of cash flows shows all movements of cash and cash equivalents into and out of a
business during the accounting period. These cash flows are classified into operating, investing and
financing activities. The cash flows for each of these are totalled to give the net inflow or outflow of
cash for the period.
The statement of cash flows is covered in more detail in Module 3.

Question 19: Accounting information

The financial statements of a limited liability company will consist solely of the statement of financial
position and statement of profit or loss and other comprehensive income.
This statement is
A correct.
B not correct.
(The answer is at the end of the module.)
 FINANCIAL ACCOUNTING AND REPORTING | 87

KEY MODULE POINTS 4

 Transactions and other events are grouped together in broad classes and in this way their financial
effects are shown in the financial statements. These broad classes are the elements of financial
statements.
 Financial position is shown by:
– assets
– liabilities
– equity.
 Financial performance is shown by:
– income
– expenses.
 Items which meet the definition of assets or liabilities may still not be recognised in financial
statements because they must also meet certain recognition criteria:
– it is probable that any future economic benefit associated with the item will flow to or from the
entity; and
– the item has a cost or value that can be measured reliably.
 The principal financial statements of a business are the statement of financial position and the
statement of profit or loss and other comprehensive income. Other statements include the
statement of changes in equity and the statement of cash flows.
88 | THE FINANCIAL REPORTING ENVIRONMENT

QUICK REVISION QUESTIONS 4

1 Of what is the following statement a definition?

'A resource controlled by an entity as a result of past events and from which future economic
benefits are expected to flow to the entity.'
A asset
B equity
C liability
D expense

2 Which of the following is the correct definition of a liability?

A the residual interest in the assets of the entity after deducting all its liabilities
B a present obligation arising from past events from which future economic benefits are expected
to flow to the entity
C a resource controlled by an entity as a result of past events and from which future economic
benefits are expected to flow to the entity
D a present obligation arising from past events, the settlement of which is expected to result in an
outflow of resources embodying economic benefits

3 What are the criteria for recognition of items in the financial statements according to the IASB's
Conceptual Framework?
A probable that future economic benefit will flow to or from the entity
B probable that there will be outflow of future economic benefits and there is a past transaction
C probable that there will be an inflow or outflow of future economic benefits and there is a past
transaction
D probable that future economic benefit will flow to or from the entity and the item can be
measured with reliability

4 What items are recognised in the statement of profit or loss and other comprehensive income?
I. equity
II. assets
III. income
IV. liabilities
V. expenses

A III only
B I and V only
C III and V only
D I, II, III, IV and V

5 Which of the following is an example of a current asset?

A retained earnings
B manufacturing licences
C property, plant and equipment
D motor vehicles held for sale as part of a trade
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6 Which of the following items are non-current assets?

I. land
II. inventory
III. bank loan
IV. machinery

A I only
B I and IV only
C I, III and IV only
D II, III and IV only

7 How is a bank overdraft classified in the statement of financial position?

A current asset
B current liability
C non-current asset
D non-current liability

8 How should the balance of accounts payable be reported in the financial statements?
A as an expense
B as a current asset
C as a current liability
D as a non-current asset

9 Which of the following is an example of a liability?

A loan
B inventory
C receivables
D plant and machinery