ACCG224 – Session 1, 2013 Week 2

1. ACCG224 – Session 1, 2013Week 2 Conceptual Framework and Disclosure: Legal Requirements and Accounting Policies

2. Learning objectives – part 1 Conceptual Framework: • Explain the nature of the Conceptual Framework for Financial Reporting. • How does the Conceptual Framework differ from accounting standards? • What are the reasons, benefits and criticisms of the Conceptual Framework? • Explain the history of the development of the Conceptual Framework and its current status. • Describe the nature of a reporting entity under the Conceptual Framework.

3. Learning objectives – part 1 (cont’d) Conceptual Framework (cont’d): • Describe the objectives of general purpose financial statements under the Conceptual Framework. • Identify the qualitative characteristics for the selection and presentation of financial information. • Define the elements in financial statements (assets, liabilities, equity, income, expenses). • Describe the recognition criteria established in the Conceptual Framework for assets, liabilities, income and expenses.

4. Learning objectives – part 2 Disclosure: • Describe a complete set of financials statements. • Explain the eight general features of financial statements. • Discuss the legislative annual reporting requirements for companies. • Explain how accounting policies and changes to them are disclosed. • Describe how changes in accounting estimates are accounted for and disclosed. • Describe how prior period errors are corrected and accounted for. • Explain how events after the reporting period are treated.

5. The Conceptual Framework • What is a framework? • ‘A pattern of ideas brought together to form a consistent whole or a frame of reference (Vatter, 1947); • ‘A set of ideas or principles used to plan’. • It is a normative theory • What is the Conceptual Framework of Financial Reporting? • ‘A coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards’; • Also, it is an attempt to provide a structured theory of accounting that prescribes practice.

6. The Conceptual Framework (cont’d) • Purpose and status: • establishes concepts/ideas that underlie the preparation and presentation of financial reports; • assists standard setters, preparers, auditors, users and those interested in the work of standard setters. • Scope: • deals with objectives of financial reports (users, purpose); • establishes qualitative characteristics that determine usefulness of financial information; • defines elements of financial statements (assets, liabilities, equity, income, expenses); • establishes principles of measurement (concepts of capital); • concerned with general purpose financial statements (GPFS).

7. The Structure And Components Of The Conceptual Framework • The Conceptual Framework can be seen as providing answers to questions such as: • What is the purpose of financial statements? • Who are they prepared for? • What are the assumptions to be made when preparing financial statements? • What type of information should be included? • What are the elements that make up financial statements? • When should the elements of financial statements be included?

8. How does it differ from an accounting standard? • Conceptual Framework is not an accounting standard – it is a set of principles to be followed when preparing and presenting financial statements. • General concepts or principles – designed to provide guidance in the preparation of financial statements. • Accounting standards – specific requirements for a particular area of financial reporting, may go beyond the framework, are mandatory and sometimes conflict with the framework. • Conceptual Framework – more broadly defines what is an asset/liability and when it should be included in financial statements.

10. Why have a framework? • More consistent and logical standards – developed from orderly set of concepts; • Increased international comparability; • Standard setting more transparent – discharging the accountability of standard setters; • Should be followed when preparing and presenting financial statements but do not have to be followed; • Emphasis on decision usefulness as well as stewardship.

11. Why have a framework? (cont’d) • Unwise to develop standards unless there is agreement on: • scope and objectives of financial reporting; • what sort of entities should produce financial reports; • underlying assumptions; • recognition and measurement rules; • qualitative characteristics of financial information; • elements of financial reporting.

12. The framework – benefits • Technical: • To improve the practice of accounting by providing guidance; • Helping preparers and auditors; • Helps in decision making (eg. in the case of asset or expense); • Sets principles as a basis for understanding specific accounting standards.

13. The framework – benefits (cont’d) • Political: • Impact of decision made on the basis of accounting information; • Changes in accounting standards have ‘economic consequences’; • Guard against political interference. • Professional: • Protects the accounting profession; • Maintains the status of the profession of members; • Establishment of a unique body of knowledge.

14. The framework – criticisms • Precedence of economic issues over social issues; • economic decision making is not the only thing; • ignoring events not resulting from market transactions; • ignores environmental externalities caused by business; • no social performance indicators as guides to success; • costly for smaller businesses to comply;

15. The framework – criticisms (cont’d) • codification of existing practice; • striking a bargain with the government not to intervene in the profession; • ambiguous and open to interpretation; • principles are too vague; • not prescriptive enough - the Conceptual Framework simply describes current accounting practise.

16. Development of the Conceptual Framework • In Australia, the AASB developed in the 1990’s four statements of accounting concepts (SAC): • SAC 1: Definition of the Reporting Entity; • SAC 2: Objective of General Purpose Financial Reporting; • SAC 3: Qualitative Characteristics of Financial Information; • SAC 4: Definition and Recognition of the Elements of Financial Statements.

17. Development of the Conceptual Framework (cont’d) • With the adoption of IFRS in Australia 2005, AASB issued a new framework: • equivalent of the IASB’sFramework for the Preparation and Presentation of Financial Statements; • however, SAC 1 and 2 were retained as ‘reporting entity’ and ‘objectives’ were not detailed enough in the IASB’s framework.

18. Development of the Conceptual Framework (cont’d) • In October 2004, IASB and FASB agreed on a joint project for a revised Framework: • divided into eight phases; • up to date, only first phase is completed, including • ‘The objective of general purpose financial reporting’ and • ‘Qualitative characteristics (QC) of useful financial information’; • two fundamental QCs: • relevance and faithful representation; • supported by enhancing QCs: • comparability, verifiability, timeliness and understandability; • the remaining parts of the old framework (1989) remain in place.

19. Development of the Conceptual Framework (cont’d) • AASB decided to wait for completion of the project: • latest versions of the AASBFramework for the Preparation and Presentation of Financial Statements (2009) and SAC 1 and 2 in Australia still in place; • however, we will base our discussions on the new parts of the IASB framework regarding: • objective of general purpose financial reporting and • qualitative characteristics of useful financial information.

20. Overview of the Conceptual Framework On the following slides we will discuss: • Reporting entity (SAC 1) • Objectives of general purpose financial reporting (new IASB framework) • Qualitative characteristics of useful financial information (new IASB framework) • Elements in financial statements: assets, liabilities, equity, income and expenses (current framework and draft) • Recognition of the elements (current framework and draft) • Measurement

21. The reporting entity: SAC 1 • Entity in which it is reasonable to expect existence of users who depend on general-purpose financial reports • Indicators of their existence • Separation of management from economic interest • Economic or political importance/influence • Financial characteristics

22. The reporting entity: SAC 1 (cont’d)

23. The objectives of financial reporting • Financial information useful to present and potential equity investors, lenders and other creditors (capital providers) in making decisions for capital provision. • Capital providers are interested in assessing an entity’s ability to generate net cash flows and management’s ability to protect and enhance capital providers’ investments. • Management performance discharges stewardship – their performance in relation to cash flow is of interest. • Emphasis on evaluation of the ability of an entity to generate cash and cash equivalents – future perspective!

24. The objectives of financial reporting (cont’d) • Decisions in relation to the ability of an entity to generate cash; • Determined by reference to the following financial statements: • Statement of Financial Position • Statement of Comprehensive Income (Performance) • Statement of Cash Flows

25. Underlying assumptions ofthe framework • Accrual basis – event recorded when it occurs not when it is paid for. • Going concern – continuing operations and solvency. • True and fair view/fair presentation: • is achieved if financial statements are based on the qualitative characteristics.

26. Qualitative characteristics of financial information • Fundamental characteristics • Relevance • Will make a difference in a decision of an economic nature made by users; • It will help users form predictions about the outcome of events; • It will confirm or change their previous evaluations; • It is material; • Faithful representation • It is complete, neutral and free from material error.

27. Qualitative characteristics of financial information (cont’d) • Enhancing qualitative characteristics • Comparability – users can compare aspects of an entity over time and between entities. • Verifiability – different knowledgeable and independent users could reach consensus that a particular piece of information is a faithful representation. • Timeliness – report before all aspects of the transaction are known or too late for decision making. • Understandability– users assumed to have reasonable knowledge of accounting and will conduct a diligent review and analysis of the information.

28. Constraints on relevant and faithfully representative information • Ideally information will have all characteristics • In reality there are often trade-offs • Timeliness versus faithful representation • Relevance versus verifiability • Relevance versus understandability • Cost/benefit consideration: • costs incurred in generating information should not outweigh the benefits to be obtained from having the information; • evaluation is a matter of professional judgement.

29. A cynics view of qualitative characteristics • How realistic are they? • Accounting is a construction of reality: • Materiality a limiting factor on the disclosure of relevant and faithful materials; • Omission, misstatement or non-disclosure; • Can neutrality be achieved? • Accounting requires the exercise of professional judgment; • Costs borne by the preparers; • How much benefit is derived by the disparate group of users?

30. Elements in financial statements • Elements: • assets, liabilities and equity (financial position); • income, expenses (financial performance). • Definition: • What essential features are needed before an item can be classified as asset, liability, equity, expense or income? • Attention to substance over legal form!

31. Assets • Current definition: • 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: • Future economic benefits – contribute to cash or cash equivalents – provide goods and services in accordance with entities’ objectives; • Control of future economic benefit – deny others benefit - not necessarily legal ownership; • Past transaction.

32. Assets (cont’d) • Proposed definition: • A present economic resource to which the entity has a right or other access that others do not have: • Present economic resources; • Control – rights or privileged access to the economic resources; • Past transaction. • Current definition took away the emphasis on whether the economic resource and rights exist at the end of the financial year or not.

33. Liabilities • Current definition: • 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: • Present obligation includes legally enforceable but sometimes goes beyond to moral obligation; • A past transaction or event created the obligation; • Will result in the giving up of resources – outflow of economic resources.

34. Liabilities (cont’d) • Proposed definition: • A present economic obligation for which the entity is the obligor: • Present obligation – on the date of financial statements; • Economic obligation – unconditional promise.

35. Equity • Defined as a residual of assets minus liabilities: Equity = Assets - Liabilities • sub-classified as funds from shareholders, retained earnings, reserves; • revaluation of assets included in equity as capital maintenance adjustments or revaluation reserves.

36. Income • Definition: • 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; • made up of revenue and gains: • inflows/enhancements = increases of assets – cash/receivables; • savings in outflows of future economic benefits = decreases of liabilities; • an increase in equity results; • not contributions by owners; • can include grants, donations etc.; • can include realised and unrealised gains.

37. Expenses • Definition: • Expenses are 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 distributions to equity participants: • consumptions or losses of future economic benefits; • outflow/depletion of assets; • losses both realised and unrealised.

38. Recognition of the elements in financial statements • The process of deciding what is on or off the balance sheet and income statement. • An item which meets the definition should be recognised as asset, liability, income or expense if: • Future economic benefit/outflow is probable – based on evidence; • Cost/value can be reliably measured – based on judgement. • Do we see any problems here?

39. Measurement of the elements in financial statements • Determining the $ amount on the statement: • historical cost (HC); • current (acquisition) cost; • realisable (selling) value; • present value – discounted value of future economic benefits; • some standards also refer to fair value – exchange value. • Can $ calculations that are based on these different measurement bases be added up to meaningful (quality) information that is comparable? • Over 40 years ago, Chambers referred to this as the additivityproblem.

40. After preparation there is disclosure: AASB 101 • AASB 101 – Presentation of general purpose financial statements (GPFS) • GPFS are prepared for users who depend on reports for information to enable them to make decisions about the allocation of scarce resources. • AASB 101 does not prescribe who must prepare financial statements, but rather the format of financial statements. • Preparation is required by country law (eg Corporations Act) or entity’s constitutions (see section ‘Annual reporting requirements’).

41. Complete set of financial statements • A complete set of financial statements includes: • a statement of financial position; • a statement of comprehensive income; • a statement of changes in equity; • a statement of cash flows; • notes to support the statements.

42. Eight general features of financial statements • Faithful representation of effects of transactions/events in accordance with definition and recognition principles in the Framework and compliance with IFRSs. • Financial statements should be prepared on a going concern basis (assumption of the Framework) • Financial statements except the cash flow statements must be prepared in accordance with the accrual basis of accounting (assumption of the Framework)

43. Eight general features of financial statements (cont’d) • There needs to be consistency in presentation and classification of items unless there is a significant change in the nature of entity’s operation or an Australian accounting standard requires a change in presentation • Materiality and aggregation – Each material class of similar items must be presented separately in financial statements. Items that are dissimilar in nature or function are presented separately. Materiality depends on the size of the entity.

44. Eight general features of financial statements (cont’d) • Offsetting: Assets and liabilities, and income and expenses shall not be offset unless required or permitted by a standard: • Eg Offsetting appropriate in reporting gains and losses on disposal of non-current assets. • Frequency of reporting: Financial statements must be prepared at least annually. Companies also report half-yearly and quarterly • Comparative information in respect of previous periods needs to be disclosed.

45. Annual reporting requirementsCorporations Act 2001 • Components of an annual financial report (s295(1)): • The financial statements for the year; • The notes to the financial statements; • The directors’ declaration about the statements and notes.

46. Annual reporting requirementsCorporations Act 2001 (cont’d) • Financial Statements (s295(2)): • statement of financial position as at the end of the year; • statement of comprehensive income; • statement of changes in equity; • statement of cash flows for the year; • if required, consolidated accounts. • The notes to the financial statements (s295(3)): • the notes must contain all information necessary to ensure that the financial report provides a true and fair view of the financial position and performance of the company/consolidated entity.

47. Annual reporting requirementsCorporations Act 2001 (cont’d) • The directors’ declaration about the statements and notes • This declaration must state whether, in the directors’ opinion: • there are reasonable grounds to believe that the company is solvent — that is, able to pay its debts as and when they become due and payable; • the financial statements and notes are in accordance with the Corporations Act; and • a statement of compliance with IFRSs in the notes to the financial statements (where the entity has in fact complied with such requirements).

48. Annual auditor’s report • The auditor must form an opinion as to whether the: • financial report is in accordance with Corporations Act and AASB accounting standards; • financial report gives a true and fair view; • auditor has been given all necessary information and explanations; • company has kept financial records to enable a financial report to be prepared and audited; • company has kept registers and records required by the Corporations Act.

49. Accounting policies, estimates and errors: AASB 108 • Definitions: • Accounting policy: specific principles, rules etc. used in preparing the financial statements: e.g. policy on revaluation of property, plant and equipment. • Accounting Estimate: judgement applied in determining the carrying amount of the asset such as estimate of the useful life of an asset. • Error: Omission or misstatement in the financial statements through mathematical mistakes, mistake in applying accounting policy, oversight or fraud. • In general, changes in accounting policy and errors are handled retrospectively and changes in accounting estimates are handled prospectively.

50. Selecting and applying accounting policies: AASB 108 • Objective of AASB 108 is to prescribe the criteria for selecting and changing accounting policies. • These criteria are especially relevant where no specific standard/interpretation exists for a transaction or event (and the entity must therefore decide on its own policy). • In such cases management must use their judgement to develop and apply a policy that results in information that is both relevant and reliable for users.