Advanced Financial Accounting

Introduction - the conceptual framework for financial reporting

IFRSs terminology

IFRSs: the whole current accounting standards and interpretations (IFRS, IAS, IFRIC, SIC) issued by IASB.

IASB: International Accounting Standards Board (formerly named IASC, International Accounting Standards Committee): Independent international standard-setting body, part of the IFRS Foundation.

IFRS: International Financial Reporting Standards, accounting principles more recently published by IASB.

IAS: International Accounting Standards, accounting principles less recently published by IASB.

IFRIC Interpretations: interpretations more recently issued by IASB (through IFRS Interpretations Committee) on specific problems of application of the standards.

SIC Interpretations: interpretations less recently issued by IASB (through former Standing Interpretation Committee).

• Under revision/reconsideration.
• Amended.
• Withdrawn: e.g., IAS 22-Business Combinations, superseded by IFRS 3-Business Combinations.

Main steps of the standard setting process

Discussion paper → exposure draft → Published IFRS → Adoption by the EU or by a country → Post-implementation review.

The IFRS conceptual framework

The Conceptual Framework for Financial Reporting 2010 is not properly a standard, but it is a general guide for IASB and for national standard setters; a point of reference for preparers of financial statements.

Hierarchy of standards (IAS 8)

1. a) IAS/IFRS b) SIC/IFRIC Interpretation
2. In absence of I) → Develop an accounting policy conforming to the Conceptual Framework.
3. In absence of I) and II) → Refer to pronouncements of other standard setters, accounting literature, and industry practices not conflicting with IFRSs and Conceptual Framework.

Financial statements

Purpose

IAS 1 refers to financial statements as “a structured representation of the financial position and financial performance of an entity” and explains that the objective of financial statements is to provide information about an entity’s financial position, its financial performance, and its cash flows, which is then utilized by a wide spectrum of end users in making economic decisions. In addition, financial statements show the results of management’s stewardship of the resources entrusted to it. All this information is communicated through a complete set of financial statements which provide information about an entity’s: assets, liabilities, equity, income, and expenses (including gains and losses, cash flows).

Fair presentation and compliance with IFRSs: In accordance with IFRS, financial statements should present fairly the financial position, financial performance, and cash flows of an entity. Fair presentation means faithful representation 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 Framework.

Objective of general purpose financial statements (Framework)

To provide financial information about the reporting entity’s:

• Nature and amounts of economic resources and claims
• Changes in economic resources and claims, resulting from:
  • Financial performance: accrual-based information; cash flow
  • Other events and transactions (e.g., issuing debt or equity instruments)

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 (e.g., providing loans to the entity or buying equity instruments of the entity) (OB2).

Existing and potential investors, lenders, and other creditors are the primary users to whom general purpose financial reports are directed (OB5). They require useful information to assess the future cash flows of the entity they are evaluating. Normally, general purpose financial reports are not primarily prepared for use by management, regulators, or other members of the public, although they may also find those reports useful (OB9-OB10).

General purpose financial reports are not designed to show the value of a reporting entity. Instead, they help the primary users to estimate such value (OB7). Changes in the reporting entity’s economic resources and claims against the entity result from that entity’s financial performance and from other events or transactions such as issuing debt or equity instruments. To properly assess the entity’s future cash flow prospects, users need to be able to distinguish between both of these changes (OB15).

Accrual accounting is applied when preparing the financial statements. Accrual accounting depicts the effects of transactions and other events and circumstances on the reporting entity’s economic resources and claims against the entity in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period (OB17). However, the statement of cash flows is not prepared on an accrual basis (IAS 7).

Purpose of the conceptual framework

The purpose of the conceptual framework is to set out the concepts which underlie the preparation and presentation of financial statements. The preparation of financial statements is based on estimates, judgments, and models rather than exact depictions. The conceptual framework provides the foundations upon which these constituents are based. The main aim is to help the IASB in preparing new standards and reviewing existing standards. The conceptual framework also helps national standard setters, preparers, auditors, users, and others interested in IFRS in achieving their objectives. The conceptual framework is, however, not itself regarded as an IFRS and therefore cannot override any IFRS although there might be potential conflicts. The IASB believes that over time any such conflicts will be eliminated.

Going concern

The financial statements are normally prepared on the assumption that the entity is a going concern and will continue in operation for the foreseeable future. Thus, it is assumed that the entity has neither the intention nor the need to liquidate or curtail materially the scale of its operations. However, if such an intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed (F.4.1).

Materiality and aggregation

An entity should present separately each material class of similar items as well as present separately material items of dissimilar nature or function. If a line item is not individually material, it is aggregated with other items either in the financial statements or in the notes. An item which is not considered sufficiently material to justify separate presentation in the financial statements may warrant separate presentation in the notes. It is not necessary for an entity to provide a specific disclosure required by an IFRS if the information is not material. In general, an item presented in the financial statements is material — and therefore is also relevant — if its omission or misstatement would influence or change the economic decisions of users made on the basis of the financial statements. Materiality depends on the relative size and nature of the item or error, judged in the particular circumstances.

Offsetting

Assets and liabilities, or income and expenses, may not be offset against each other unless required or permitted by an IFRS. Offsetting in the statement of comprehensive income (or statement of profit or loss, if presented separately) or statement of financial position is allowed in rare circumstances when it more accurately reflects the substance of the transaction or other event. For example, IAS 37 allows warranty expenditure to be netted against the related reimbursement under a supplier’s warranty agreement.

Frequency of reporting

An entity should present a complete set of financial statements (including comparative information) at least annually. If the reporting period changes such that the financial statements are for a period longer or shorter than one year, the entity should disclose the reason for the longer or shorter period and the fact that the amounts presented are not entirely comparable.

Comparative information

Unless IFRS permit or require otherwise, comparative information of the previous period should be disclosed for all amounts presented in the current period’s financial statements. Comparative narrative and descriptive information should be included when it is relevant to an understanding of the current period’s financial statements. As a minimum, two statements of financial position, as well as two statements of comprehensive income, changes in equity, cash flows, and related notes, should be presented.

Characteristics of financial information

Qualitative characteristics of useful financial information

No hierarchy of applying the qualitative characteristics is determined. The application is, however, a process. The fundamental characteristics are applied by following a three-step process. Firstly, it is necessary to identify the economic phenomenon which has the potential to be useful. Secondly, the type of information regarding the phenomenon that is most relevant and could be faithfully represented should be identified. Finally, it should be determined whether the information is available and could be faithfully represented. After that, the enhancing characteristics are applied to confirm or enhance the quality of the information.

Fundamental qualitative characteristics

Relevance

Financial information is relevant if it is capable of making a difference in the decisions made by users (QC6). Financial information is capable of making a difference in decisions if it has predictive value, confirmatory value, or both (QC7). Predictive value means that the financial information can be used as an input to processes employed by users to predict future outcomes. Confirmatory value means that the financial information provides feedback about (i.e., confirms or changes) previous evaluations (QC9). Materiality: financial information about a specific reporting entity is material if omitting it or misstating it could influence the decisions of users; it is based on the magnitude or nature, or both, of the items to which the information relates in the context of an individual entity’s financial report. Hence, the IASB cannot specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation (QC11).

The practice statement provides an overview of the general characteristics of materiality and presents a four-step process companies may follow in making materiality judgments when preparing their financial statements; guidance on how to make materiality judgments in specific circumstances; namely, how to make materiality judgments about prior-period information, errors, and covenants, and in the context of interim reporting.

Faithful representation

A faithful representation of economic phenomena should be:

• Complete: includes all information necessary for a user to understand the economic phenomenon being depicted (QC12).
• Neutral: without bias in the selection or presentation of information. A neutral depiction is not slanted, weighted, emphasized, de-emphasized, or otherwise manipulated in order to increase the probability that the information will be received favorably or unfavorably by users (QC14).
• Free from error: that there are no errors or omissions in the description of an economic phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. Nevertheless, free from error does not mean perfectly accurate in all respects. For example, there is always some uncertainty when estimating an unobservable price or value (QC15).

Enhancing qualitative characteristics

The enhancing qualitative characteristics enhance the usefulness of information that is relevant and faithfully represented. However, they cannot make information useful if that information is irrelevant or not faithfully represented. They may also help to determine which of two ways should be used to depict an economic phenomenon if both are considered equally relevant and faithfully represented (QC19 and QC33). Enhancing qualitative characteristics should be maximized to the extent possible. However, one enhancing qualitative characteristic may have to be diminished in order to maximize another qualitative characteristic.

• Comparability: Information about a reporting entity is more useful if it can be compared with similar information about the same entity for another period or another date and with similar information about other entities (QC20). Consistency, although related to comparability, is not the same. Consistency refers to the use of the same methods for the same items, either in a single period across entities or from period to period, within the reporting entity. Comparability is the goal whereas consistency helps to achieve that goal (QC22).
• Verifiability: Means that different knowledgeable and independent observers could reach consensus although not necessarily complete agreement that a particular depiction constitutes a faithful representation (QC26).
• Timeliness: Having information available to decision-makers in time to be capable of influencing their decisions. Normally, the older the information is, the less useful it is (QC29).
• Understandability: Information is made understandable by classifying, characterizing, and presenting it clearly and concisely (QC30).

The elements of financial statements

Definitions

The elements directly related to the measurement of financial position are defined as follows in the Conceptual Framework (F.4.4):

• An asset is a resource which is controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
• A liability is a present obligation of the entity that arises from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
• Equity is the residual interest in the assets of the entity after deducting all its liabilities.

Furthermore, the elements of performance are defined in the Conceptual Framework as follows (F.4.25):

• Income encompasses increases in economic benefits during the 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.
• Expenses are decreases in economic benefits during the period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.

Income encompasses both gains (e.g., from the disposal of non-current assets) and revenue (e.g., from the sale of merchandise). Similarly, expenses encompass losses as well as other expenses.

Recognition

Recognition is the process of incorporating an element in the statement of financial position or in the statement of comprehensive income (F.4.37).

• An asset is recognized in the statement of financial position when it is probable that the future economic benefits associated with the asset will flow to the entity and the asset has a cost or value that can be measured reliably (F.4.44).
• A liability is recognized in the statement of financial position when it is probable that an outflow of resources which embody 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 (F.4.46).

Chapter 1 - IAS 1, presentation of financial statements

Components of the financial statements

An entity’s financial statements consist of the following components (IAS 1.10):

• A) A statement of financial position (balance sheet). (In some cases, it is necessary to present an additional statement of financial position as at the beginning of the preceding period) at the end of the period.
• B) Either for the period
  • B1) A single statement of comprehensive income (one statement approach)
  • B2) A separate income statement and a statement of comprehensive income (two statement approach)
• C) A statement of changes in equity for the period
• D) A statement of cash flows for the period
• E) Notes: the notes contain information supplementary to that which is presented in the other components of the financial statements (IAS 1.7).

Financial statements, except for cash flow information, are to be prepared using the accrual basis of accounting.

In accordance with IAS 1, the notes should: (1) present information about the basis of preparation of the financial statements and the specific accounting policies used; (2) disclose the information required by IFRS which is not presented elsewhere in the financial statements; and (3) provide information which is not presented elsewhere in the financial statements but is relevant to an understanding of any of them.

An entity should present notes in a systematic manner and should cross-reference each item in the statements of financial position and of profit or loss and other comprehensive income, or in the separate statement of profit or loss (if presented), and in the statements of changes in equity and of cash flows, to any related information in the notes.

Statement of profits and loss and other comprehensive income

IAS 1 states that comprehensive income is the change in the entity’s net assets over the course of the reporting period arising from non-owner sources. An entity has the option of presenting comprehensive income in a period either in one statement or in two statements. The IASB initially intended to introduce the single-statement approach for the statement of comprehensive income, but during discussions with constituents, many of them were opposed to the concept of a single statement, stating that it could result in undue focus on the “bottom line” of the statement.