Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-1 Chapter 2 The conceptual framework of accounting and its relevance to financial reporting

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-2 Objectives of this lecture Understand the role of a conceptual framework of accounting Be able to explain the structure, or building blocks, of a well-developed conceptual framework Be able to define the elements of financial reporting Be able to explain the recognition criteria of the elements of accounting Be able to explain the meaning of ‘reporting entity’ Understand the objectives of general purpose financial reporting

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-3 Objectives (cont.) Understand the desirable qualitative characteristics that financial information should possess Be able to define the users of general purpose financial statements Be aware of the joint initiative being undertaken by the IASB and FASB to develop a revised conceptual framework Be able to critically evaluate the existing conceptual framework

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-4 Conceptual framework—an introduction From 2005 Australia adopted IFRS and replaced the Australian Conceptual Framework with the IASB Framework Conceptual frameworks prescribe the nature, function and limits of financial accounting and reporting Central goal in establishing a conceptual framework is to generate consensus on such things as: –Scope and objectives of financial reporting –The qualitative characteristics that financial information should possess –Elements of financial reporting together with their recognition criteria

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-5 Benefits from having a conceptual framework Accounting standards would be more consistent and logical Increased international comparability of financial information Should result in IASB, AASB and constituents being more accountable for their standard-setting decisions through enhanced communication More economical accounting standard development

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-6 Current initiatives to develop a revised conceptual framework Australia uses the IASB Conceptual Framework United States use their own conceptual framework FASB as they have not adopted either IFRSs or the IASB Framework As a result, the IASB and FASB are jointly developing a revised conceptual framework A revised conceptual framework is also necessary because of the joint efforts of the IASB and FASB to converge their accounting standards—with uniform accounting standards there is also a need to have a uniform conceptual framework

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-7 The discussion that follows will relate to the existing IASB Conceptual Framework for Financial Reporting (as released by IASB in 2010), but it needs to be appreciated that this framework will continue to be refined across future years Current initiatives to develop a revised conceptual framework (cont.)

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-8 Structure of the Conceptual Framework Until 2004, only four Statements of Accounting Concepts (SACs) had been issued within Australia From 2010 Australia adopted the IASB Conceptual Framework supplemented with SAC 1 Definition of the Reporting Entity Once the IASB Conceptual Framework addresses the ‘reporting entity’ concept,SAC 1 will be withdrawn, and the AASB website updated IASB and FASB are undertaking work on the conceptual framework in eight phases. As at mid 2012, phase A had been completed and phases B, C and D were active

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-9 Current framework Looking at the Conceptual Framework for Financial Reporting, as released by the IASB in 2010, we find the following sections: INTRODUCTION Purpose and status Scope

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-10 CHAPTERS 1. The objective of general purpose financial reporting 2. The reporting entity [to be added at a future date—in Australia we will therefore continue to rely on SAC 1] 3. Qualitative characteristics of useful financial information 4. The Framework (1989): Underlying assumptions The elements of financial statements Recognition of the elements of financial statements Measurement of the elements of financial statements Concepts of capital and capital maintenance Current framework (cont.)

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-11 Legal status of Conceptual Framework Paragraph 11 of AASB 108 Accounting Policies, Changes in Accounting Estimates, and Errors requires the preparers of general purpose financial statements to follow the Conceptual Framework. Accounting standards have precedence over the Conceptual Framework, but in the absence of a specific accounting standard then the Conceptual Framework must be followed.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-12 Sequence for components of CF

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-13 Consideration of the building blocks of a CF The first matter to be addressed is the definition of financial reporting. Unless there is some agreement on this it would be difficult to construct a framework for financial reporting Having determined what ‘financial reporting’ means, we then turn our attention to the subject of financial reporting— specifically which entities are required to produce general-purpose financial statements, and the likely characteristics of the users of these statements Then we look at the objective of financial reporting

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-14 Once we have determined the objective of financial reporting, the next step is to determine the basic underlying assumptions and qualitative characteristics of financial information necessary to achieve the stated objective We can then define the elements of financial reporting, their respective recognition criteria, and the basis of measurement Consideration of the building blocks of a CF (cont.)

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-15 What are general-purpose financial statements and reporting entities? Australia has elected to retain the use of SAC 1 Definition of the Reporting Entity to supplement to the IASB Conceptual Framework Financial Reporting (2010) until addressed in the IASB Conceptual Framework. SAC1—Definition of the Reporting Entity Defines general-purpose financial statements General purpose financial statements are required to be released by ‘reporting entities’ who have users who cannot command the preparation of specific information

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-16 Reporting entities Factors that may indicate that an entity is a ‘reporting entity’ include: –Separation of management from those with an economic interest in the entity –Economic or political importance/influence Financial characteristics to be considered are: –Amount of sales, value of assets, extent of indebtedness –Number of customers and employee Small proprietary companies are frequently not considered to be reporting entities An entity deemed to be a reporting entity is expected to provide financial statements in accordance with accounting standards

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-17 The users of financial statements Identified potential users of financial statements and their main information needs –The IASB Conceptual Framework identified existing and potential investors, lenders and other creditors who must rely on general purpose financial reports for much of the financial information they need. They are the primary users to whom general purpose financial reports are directed. Other potential users the IASB Conceptual Framework identified –Other parties, such as regulators and members of the public other than investors, lenders and other creditors, may also find general purpose financial reports useful.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-18 The IASB Conceptual Framework assumptions about user knowledge –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 need to seek the aid of an adviser to understand information about complex economic phenomena. The users of financial statements (cont.)

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-19 Objectives of GPFSs According to the IASB Conceptual Framework: 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. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit. The rest of the conceptual framework is developed around this objective.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-20 Qualitative characteristics of financial information The IASB Conceptual Framework identifies the characteristics of financial information necessary: 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. There are two 'fundamental qualitative characteristics' of financial information and four 'enhancing qualitative characteristics'

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-21 Fundamental qualitative characteristics The fundamental qualitative characteristics identified in the IASB Conceptual Framework for Financial Reporting (as released in 2010) are: –‘relevance’ and –‘faithful representation’ This represents a departure from the previous IASB Framework for the Preparation and Presentation of Financial Statements wherein the primary qualitative characteristics were considered to be –‘relevance’ and –‘reliability’ Therefore, faithful representation has replaced reliability

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-22 The need for information to be both relevant and faithfully represented In discussing the need for information to be relevant and faithfully represented, the IASB Conceptual Framework states: Information must be both relevant and faithfully represented if it is to be useful. Neither a faithful representation of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon helps users make good decisions. When information is representationally faithful, but not very relevant, or the other way around it is not be deemed to be useful.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-23 Relevance According to the IASB Conceptual Framework: Relevant financial information is capable of making a difference in the decisions made by users. Information may be capable of making a difference in a decision even if some users choose not to take advantage of it or are already aware of it from other sources. The are two main aspects to relevance are predictive value and confirmatory value (or feedback value). Closely tied to relevance is the concept of materiality. If an item of information is not deemed material, the mode of disclosure or even whether it is disclosed at all should not affect the decisions of financial statement readers. Guidelines for materiality are provided in AASB 1031 Materiality

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-24 Faithful representation Apart from ‘relevance’ the other primary qualitative characteristic is ‘faithful representation’. According to the IASB Conceptual Framework: To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error. Financial information that faithfully represents a particular transaction or event will depict the economic substance of the underlying transaction or event which is not necessarily the same as its legal form.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-25 Does not mean total absence of error Most financial reporting measures involve various estimates and instances of professional judgement. An estimate must be based on appropriate inputs and each input should reflect the best available information. Faithful representation (cont.)

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-26 Enhancing qualitative characteristics Apart from the two fundamental qualitative characteristics of relevance and faithful representation, in order of priority there are also four ‘enhancing qualitative characteristics’. These enhancing qualitative characteristics are: –comparability –verifiability –timeliness –understandability Each of these qualitative characteristics is assumed to enhance the usefulness of information that is both relevant and faithfully represented.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-27 As the IASB Conceptual Framework states: If financial information is to be useful, it must be relevant and faithfully represents what it purports to represent. The usefulness of financial information is enhanced if it is comparable, verifiable, timely and understandable. Enhancing qualitative characteristics (cont.)

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-28 Comparability To facilitate the comparison of the financial statements of different entities, methods of measurement and disclosure must be consistent, but should be changed if no longer relevant to an entity’s circumstances. Desirable characteristics such as comparability therefore imply that there are advantages in restricting the number of accounting methods that can be used by reporting entities. Restricting the accounting methods available for use by reporting entities (and therefore assist comparability) may reduce the efficiency with which organisations operate Alternatively restricting the use of such a method might reduce in the efficiency with which external parties can monitor the performance of the entity

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-29 Verifiability Verifiability refers to the ability, through consensus among measurers, to ensure that information represents what it purports to represent, or that the chosen method of measurement has been used without error or bias. In relation to the enhancing qualitative characteristic of verifiability, the IASB Conceptual Framework states: Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-30 Timeliness A third ‘enhancing’ qualitative characteristic is ‘timeliness’ The more ‘timely’ (or up-to-date) that financial information is, the more useful it will be As the IASB Conceptual Framework states: Timeliness means having information available to decision- makers in time to be capable of influencing their decisions. Generally, the older the information is the less useful it is.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-31 Understandability The fourth and final ‘enhancing’ qualitative characteristic is ‘understandability’. Information is considered to be understandable if it is likely to be understood by users with some business and accounting knowledge. Therefore the expectation is that financial information is not understandable by everybody. As the IASB Conceptual Framework states: Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently. At times, even well-informed and diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-32 Elements of accounting Five elements of accounting are defined in the AASB Framework –Assets –Liabilities –Equity –Expenses –Income

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-33 Asset definition We need to appreciate that the elements of financial reporting have both a definition and a separate recognition criteria—both of which we need to be familiar with An asset is defined as: a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-34 Asset definition (cont.) Three key characteristics of the definition: 1.There must be future economic benefits 2.The reporting entity must control the future economic benefits 3.The transaction or other event giving rise to the control must have occurred

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-35 Asset recognition An asset is to be recognised in the financial statements if: –It is probable that any future economic benefit associated with the asset will flow to or from the entity; and –The item has a cost or value that can be measured with reliability –An asset can be reinstated (subject to requirements in particular accounting standards)

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-36 Liability definition Liabilities are defined as: 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 There are three main characteristics: 1.There must be a future disposition or sacrifice of economic benefits to other entities 2.It must be a present obligation 3.A past transaction or other event must have created the obligation

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-37 Liability recognition Recognition in financial statements consistent with those of assets: a liability is recognised when it is probable that an outflow of resources embodying 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 Where a liability cannot be reliably measured but is potentially material, the liability should be disclosed within the notes to the financial statements—defined as a contingent liability

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-38 Liabilities do not necessarily need to be ‘legally enforceable’ An essential characteristic of a liability is that the entity has a present obligation. Obligations can be legally enforceable An equitable obligation is governed by social or moral sanctions or custom rather than legal sanctions. A constructive obligation is created, inferred or construed from the facts in a particular situation rather than contracted by agreement with another entity or imposed by government The IASB and FASB in 2008 suggested a revised definition of liabilities, this being ‘a present economic obligation that is enforceable against the entity’.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-39 Expense definition The definition is dependent upon the definitions of ‘assets’ and ‘liabilities’ Expenses are defined as: –decreases in economic benefits during the accounting 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 equity participants

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-40 Expense recognition Usual tests of probability and measurability apply Expenses are recognised in the statement of comprehensive income when: a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably. This means, in effect, that recognition of expenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in assets (for example, the accrual of employee entitlements or the depreciation of equipment) If a resource is used up or damaged by an entity but that entity does not control the resource (not an asset of the entity), to the extent that no liabilities or fines are imposed, no expenses will be recorded by the entity

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-41 Income definition Again, the definition is dependent on those of ‘assets’ and ‘liabilities’ Income is defined as: –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

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-42 Income recognition Income can be recognised in the financial statements when: –it is probable that the inflow or other enhancement or saving in outflows has occurred; and –the inflow or other enhancement or saving in outflows of economic benefits can be measured reliably

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-43 Income subdivided into ‘revenues and gains’ ‘ Revenues’ and ‘gains’ are subdivided in the Conceptual Framework –Revenue arises in the course of the ordinary activities of an entity and includes: sales, fees, interest, dividends, royalties, and rent –Gains represent other items that meet the definition of income and might or might not arise in the ordinary activities of an entity, e.g. disposal of non-current assets –Some professional judgment is required to determine whether a component of income should be classified as revenue or a gain

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-44 Definition of equity Equity is defined as: residual interest in the assets of the entity after deducting all of its liabilities Directly a function of the definitions given to assets and liabilities No need for separate recognition criteria for equity

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-45 Measurement principles Conceptual frameworks have provided little guidance in relation to measurement issues Phase C of the joint IASB and FASB Conceptual Framework Project addresses measurement issues and have identified nine potential measurement bases. It will be a number of years before any conclusion is reached about the most appropriate measurement basis or bases for assets and liabilities. As at early 2012 it appeared that work on developing the measurement component of the Conceptual Framework had stalled.

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-46 Critical review of conceptual frameworks Objective of general purpose financial reporting implies that reports should be primarily economic in focus –Should social issues be ignored in the annual report? In determining whether or not an entity is a reporting entity, should the information needs of parties that are not 'existing and potential investors, lenders and other creditors' be given greater consideration? Other stakeholders, who arguably have an interest in the financial performance of an entity, seem to be ignored?

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-47 Critical review of conceptual frameworks (cont.) Economic focus of GPFSs ignores transactions or events not resulting from market transactions or an exchange of property rights Ignores environmental externalities caused by business Financial press also generally use financial indicators as a guide to a firm’s success

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 2-48 It has also been argued that: Conceptual frameworks simply codify existing practice and therefore provide little hope for improving financial reporting Conceptual frameworks have been used as devices to legitimise the existence of the accounting profession Critical review of conceptual frameworks (cont.)