International Financial Accounting (IFA) Part I Accounting Regulation; Normative Theories of Accounting DEPARTMENT OF BUSINESS AND LAW ROBERTO DI PIETRA SIENA, NOVEMBER 4, 2013 1 INTERNATIONAL FINANCIAL Part I Accounting Regulation International Accounting Normative Theories of Accounting 2
Users and their information needs (Before 2008) The Framework regards investors as the primary, overriding user group The Framework notes that FSs cannot provide all the information that users may need to make economic decisions FSs show the financial effects of past events and transactions, whereas the decisions that most users of FSs have to make relate to future The information in FSs helps users to make their own forecasts 3 Users and their information needs After IASB-FASB Convergence project (2008 ED) The primary user group includes both present and potential equity investors, lenders and other creditors, regardless of how they obtained, or will obtain, their interests Users of financial reports are assumed to have a reasonable knowledge of business and economic activities and to be able to read a financial report In making decisions, users also should review and analyse the information with reasonable diligence 4
Responsibility for FSs The management of an entity has the primary responsibility for preparing and presenting the entity s FSs This responsibility is noted in the auditor s report in most countries Some countries require that company management include, as part of the FSs, an explicit statement of management s responsibility for the FSs 5 Responsibility for FSs The auditor s responsibility is to form and express an opinion as to whether the FSs are prepared in accordance with IFRS or some other identified financial-reporting framework The fact that FSs are audited does not relieve management of its fundamental responsibility In a converse case this could show a sort of conflict of interest that could affect the expression of an independent opinion ISA 700 on the Auditor s Report on FSs requires that the auditor s report include a statement that the FSs are the responsibility of the entity s management 6
The Objective of FSs Is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions Decision usefulness is an objective of FSs (this has been subject of heated debate) 7 The Objective of FSs On the basis of the various normative theories of accounting the objective of the Financial reports could be referred to The Stewardship theory Understand whether the resources entrusted to management have been used for their intended or appropriate purposes; the historical cost accounting enables management to report effectively on the stewardship of resources The Decision usefulness approach The main aim of financial reports is to support the rational decisions of users The Accountability approach The duty to provide an account or reckoning of those actions for which one is held responsible 8
The Objective of FSs From one hand the objective as set out in the IASB Framework is to help people to make decision From the other hand large part of the decisions are future-oriented Some disagree with this objective They argue that the FSs is strictly to be a scorecard of the past (stewardship objective of FSs) The IASB Framework does not reject this objective, but it says that people want to know about the past (stewardship) not merely out of curiosity, but because they want to use the information about the past to help them in making future-oriented economic decisions 9 Information from the past The Objective of Financial Statements Decision as a predictive process Time series Actualized Values 10
The Objective of FSs Financial position The financial position of an entity is affected by economic resources under its controls, its financial structure, its liquidity and solvency and Its capacity to adapt to changes in the environment in which it operates The Balance sheet presents this kind of information 11 The Objective of FSs Performance Performance is the ability of an entity to earn a profit on the resources that have been invested in it Information about the amount and variability of profits helps in forecasting future cash flows from the entity s existing resources and in forecasting potential additional cash flows from additional resources that might be invested in the entity Information about performance is primarily provided in an Income statement (or statement of profit and loss, or statement of financial performance ) 12
The Objective of FSs Performance IAS 1 added a fourth basic financial statement: The statement showing the changes in equity It is important to look to both the income statement and the equity statement in assessing performance because several IFRS provide that certain items if income and expense should be reported directly in equity (thereby by passing the income statement) permanently or temporarily 13 The Objective of FSs Performance Some examples Changes in FV of available-for-sale financial assets are reported directly in equity until financial asset is sold Major classes of property, plant and equipment are re-measured to FV at each BS, with the change in FV reported in a revaluation reserve directly in equity Foreign currency translation adjustment arising when the FSs of a foreign operation are translated from the foreign currency into the reporting company s currency are reported directly in equity Companies have an option of reporting actuarial gains and losses on their pension funds directly in equity when they arise This value changes are part of an entity s performance, but under existing IFRSs they are not reported in the IS; They show up in the Equity statement; In assessing performance, both of those FSs must be considered 14
The Objective of FSs Changes in financial position Users of FSs seek information about the sources and users of an entity s cash and cash equivalents such as bank deposits during the reporting period Cash comes into and goes out of an entity from 3 broad categories of activity Its operations (producing and selling its goods and services) Its investing activities (buying and selling long-lived assets and financial investments) Its financing activities (raising and repaying debt and equity capital) 15 The Objective of FSs Changes in financial position The Cash Flow Statement (CFS) provides this kind of information All investors, creditors, and other capital providers to an entity want to get cash out of their investment The cash flow statement helps them assess the prospects of receiving cash from the entity 16
The Objective of FSs Notes and Supplementary schedules The FSs also contain notes and supplementary schedules and other information that Explain items in the balance sheet and IS Explain any resources and obligations not recognised in the BS The notes also sometimes contain information that meets disclosure requirements arising under national laws or regulations 17 Accounting Concepts Going concern Accruals Matching Entity Materiality Time period Historical cost/fair value Duality Prudence Substance over form Consistency Separate determination Recognition Measurement 18
Going concern Is the assumption that an entity will continue in operational existence with the foreseeable future Any user when looking at en entity s financial statements has the right to assume that the company is not going to liquidate or curtail materially the scale of its operations Accruals Is concerned with allocating expenses and income to the periods to which their relate The transactions should be recorded in the accounting records and reported in the financial statements in the period in which they relate 19 Matching Refers to the assumption that in the measurement of profits, costs should be set against the revenue that they generate at the time when this arises Entity This concept allows the user to look at a reporting entity s financial statements and to know that these represent the performance and financial position of the business unit and do not include assets, liabilities, income and expenditure that are not related to the business 20
Materiality Affects every transaction and every set of financial statements Affects two main areas: Presentation (only material items should be disclosed in FSs) Application of accounting standards (is when deciding whether to comply with guidance given in accounting standards) Time period Refers to the practice of dividing the life of an entity into discrete periods for the purpose of preparing FSs The norm is one year The period is different to one year, the FSs need to make it clear that this is the case 21 Historical cost Allows a user to assume that all the transactions in an entity s FSs reflect the actual cost price billed, or revenue charged, for items Allows the reader to see the history of the management team s investment decision-making from the statement of financial position Fair value The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm s length transaction 22
Money measurement Allows the user to assume that the performance and financial position of a reporting entity will be expressed in monetary amounts Duality (dual aspect or double entry) Assumes that every transaction has two aspects (and due to this affects two accounts in a set of FSs in such a manner as to keep the accounting equation in balance) 23 Prudence Assumes that the FSs have been prepared on a prudent basis The user have to be confident that no profits are included that are not earned and, if not yet received, are reasonably certain to be received Expenses are complete and are not understated Assets are not overstated Liabilities are complete and not understated Substance over form Assumes that when accounting for transactions the preparer should look at the economic substance of a transaction, not its legal form This concept was introduced to try to stop the accounting practices that had emerged of creating complicated legal transactions which allowed transactions to be omitted from the FSs 24
Consistency Allows the user to look at a set of FSs over a number of years for an entity and to assume that the same methods, policies and estimation techniques have been used from year to year Separate determination An entity shall not offset assets and liabilities or income and expenses, unless required or permitted by an IFRS Company law does not allow netting, except in some limited instances 25 Recognition Is the process of including an item in either the Statement of Financial Position or in the Statement of Financial Performance Measurement Is the process of determining the monetary amounts at which the elements of the FSs are to be recognised and carried in the Statement of Financial Position and the Statement of Comprehensive Income 26
Underlying assumptions Going concern The FSs presume that an entity will continue in operation indefinitely An entity that is not a going concern is likely to be liquidated in the near term The users of the FSs of such an entity will have a great interest in the net amount of cash that can be generated from the entity s assets in the very short term IFRS are not necessarily designed to provide this kind of information presume that entity will continue to operate for the foreseeable future and therefore will generate its cash flows from operations rather than from liquidation sales 27 Qualitative characteristics Fundamental Enhancing Relevance Faithful representation Comparability Verifiability Understandability Materiality Complete Neutral Free from errors Timeliness 28
Fundamental qualitative characteristics of FSs Relevance Information in FSs is relevant when it influences the economic decisions of users It can do that by Helping users to evaluate past, present or future events relating the entity Conforming or correcting past evaluations users have made A sub-characteristic under the relevance is Materiality 29 Fundamental qualitative characteristics of FSs Relevance Materiality: is a component of relevance Information is material if its omission or misstatement could influence the economic decisions of users Conversely if information does not have a bearing on the economic decisions of users, it is immaterial Neither the IASB Framework nor individual IFRS provide quantified measures of materiality (some traces are in IAS 14 and IAS 19) 30
Fundamental qualitative characteristics of FSs Faithful representation To be faithful, information must represent accurately the transaction or other circumstance that the information purports to present To be a perfectly faithful representation, a depiction would have 3 sub-characteristics: Completeness Neutrality Free from errors (Reliability) 31 Fundamental qualitative characteristics of FSs Faithful representation Completeness Faithful representation requires that the FSs must report what they purport to report completely, subject to constraints of cost and materiality Omissions make FSs just as wrong as unreliable or irrelevant information 32
Fundamental qualitative characteristics of FSs Faithful representation Neutrality The Framework is clear that accounting information must be decision-neutral This means that information is not designed in a way that intentionally leads the users of that information to make an economic decision that the preparer of the information would like them to make Saying that accounting information should be decision-neutral is entirely consistent with saying that accounting information should be relevant Relevance requires that the information bear on the economic decisions that users want to make 33 Fundamental qualitative characteristics of FSs Faithful representation Free from errors Information in FSs is faithful if it is free from material error and bias and can be dependent on by users to represent events and transactions faithfully 34
Enhancing qualitative characteristics of FSs Comparability, Verifiability, Timeliness and Understandability are qualitative characteristics that enhance the usefulness of information that is relevant and faithfully represented 35 Enhancing qualitative characteristics of FSs Comparability User must be able to compare the FSs of an entity over time so that they can identify trends in its financial position and performance Users must also be able to compare the FSs to different entities to make decisions about where to invest their capital and at what price Disclosure of accounting policies is essential for comparability 36
Enhancing qualitative characteristics of FSs Verifiability Verifiability means that different knowledgeable and independent observers could reach consensus that a particular depiction is a faithful representation Verification con be direct and indirect Direct verification means verifying an amount or other representation through direct observation (i.e. checking counting cash) Indirect verification means checking the inputs to a model, formula or other technique and recalculating the outputs using the same methodology 37 Enhancing qualitative characteristics of FSs Timeliness To be useful, information must be provided to users within the time period in which it is most likely to bear on their decisions Generally, the older the information is the less useful it is 38
Enhancing qualitative characteristics of FSs Understandability Information should be presented in a way that is readily understandable by users Who have a reasonable knowledge of business economic activities and accounting Who are willing to study the information diligently 39 The cost constraint on useful financial reporting Balance between benefit and cost The benefits that users of FSs derive from information should exceed the cost of providing that information The evaluation of benefits and costs is a difficult judgemental process (costs of providing information should include direct and indirect costs for its preparation) 40
Balancing Qualitative characteristics of FSs Preparation Presentation Relevance Faithful representation Comparability Verifiability Timeliness Understandability 41 Constraints Cost/Benefits Can FSs provide neutral and unbiased accounts of an entity s performance and position? Despite the attribute of Faithful representation there are many forces driving the financial accounting towards specific interests Positive accounting theory There is a body of literature suggesting that those responsible for preparing FSs will be driven by self-interest to select accounting methods that lead to favourable outcomes for their own personal wealth This literature predicts that managers involved in the accounting function will always put their self-interest ahead of the interests of others Accounting regulation as a political process The process leading to finalize accounting standards can be considered political The political solutions and compromises impact on the financial information being presented and that information is an outcome of a political process 42
Conceptual framework approaches to determine profit Asset/Liability approach Links the profit to changes that have occurred in the assets and liabilities of the reporting entity Revenue/Expense approach Tends to rely on concepts such as the matching principle, which is very much focused on actual transactions and which gives limited consideration to changes in the values of assets and liabilities 43 Conceptual framework approaches to determine profit Asset/Liability approach The principal consideration is determining how account for any transaction is to determine what impact this transaction has had on increasing/decreasing the values of assets and liabilities If so this impact is effectively treated as gain or loss The Statement of Financial Position (Balance Sheet) is the primary financial statement Revenue/Expense approach The Comprehensive Income Statement (Profit and Loss Account) is the primary financial statement The IASB Framework (and FASB) adopt the Asset/Liability approach 44
Conceptual Framework General purpose FS Objective Underlying assumption Fundamental and Enhancing qualitative Characteristics Elements of the FS Definition Recognition Measurement 45 The Elements of FSs FSs portray the financial effects of transactions and other events by grouping them into broad classes according to their economic characteristics Elements directly related to financial position (BS): Assets Liabilities Equity Elements directly related to performance (IS): Income Expenses The CFS reflects both IS elements and changes in BS elements 46
The Elements of FSs Definitions of the elements relating to financial position Asset 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 Liability 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 Equity The residual interest in the assets of the entity after deducting all its liabilities 47 The Elements of FSs Assets, 3 key characteristics There must be an expected future economic benefit The reporting entity must control the resource that gives rise to these future economic benefits The transaction or other event giving rise to the reporting entity s control over the future economic benefit must have occurred Liabilities, 3 key characteristics There must be an expected future disposition or transfer of economic benefit to other entities It must be a present obligation A past transaction or other event must have created the obligation 48
The Elements of FSs Definitions of the elements relating to financial position Economic benefits means future flows of cash or other assets An assets is expected to help generate cash or other assets coming into the entity, and a liability is expected to result in cash or other assets flowing out of the entity Both the Asset and Liability definitions refer to past events 49 The Elements of FSs Definitions of the elements relating to performance Income 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 Expense Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets, or the incurrence of liabilities that result in decreases in equity other than those relating to distributions to equity participants 50
The Elements of FSs Definitions of the elements relating to performance The definition of income encompasses both revenue and gains Revenue arises in the course of the normal operating activities of the entity Gains represent other items that meet the definition of income but that do not reflect from the normal sales of goods and services produced by the entities The definition of expenses encompasses expenses and losses Expenses arise in the course of the ordinary activities of an entity (cost of sales, wages, marketing costs, administrative costs, depreciation) Losses represent other items that meets the definition of expenses and may or may not arise in the course of the ordinary activities of the entity 51 Recognition of the elements of FSs Recognition is the process of incorporating in the BS an item that meets the definition of an element and satisfies both the following criteria for recognition An item that meets the definition of an element should be recognised if It is probable that any future economic benefit associated with the item will flow to or from the entity (probability) The item s cost or value can be measured reliably (measurability) All items that satisfy these recognition criteria should be recognised in the BS or IS 52
Recognition of the elements of FSs The recognition criteria for the elements of FSs under the Framework are as follows: An asset is recognised in the BS when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably A liability is recognised in the BS 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 53 Recognition of the elements of FSs The recognition criteria for the elements of FSs under the Framework are as follows: Income is recognised in the IS when an increase in future economic benefits related to an increase in an asset or a decrease in a liability has arisen that can be measured reliably Expenses are recognised when a decrease in future economic benefits related to a decrease in an asset or an increase in a liability has arisen that can be measured reliably Because equity is the arithmetic difference between assets and liabilities, a separate recognition criterion for equity is not needed 54
Recognition of the elements of FSs Recognition of revenue from the sale of goods This revenue should be recognised when all of the following criteria have been satisfied The seller has transferred to the buyer the significant risks and rewards of ownership The seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold The amount of revenue can be measured reliably It is probable that the economic benefits associated with the transaction will flow to the seller The costs incurred or to be incurred in respect of the transaction can be measured reliably 55 Recognition of the elements of FSs Recognition of revenue from the tendering of services This revenue should be recognised when all of the following criteria have been satisfied The amount of revenue can be measured reliably It is probable that the economic benefits will flow to the seller The stage of completion at the BS date can be measured reliably The costs incurred, or to be incurred, in respect of the transaction can be measured reliably 56
Recognition of the elements of FSs Recognition of revenue from interest, royalties and dividends These revenues should be recognised when all of the following criteria have been satisfied Interest should be recognised using the effective interest method set out in IAS 39 ( 5) Royalties should be recognised on an accrual basis in accordance with the substance of the relevant agreement Dividends should be recognised when the shareholder s right to receive payment is established 57 Measurement of the elements of FSs Measurement involves assigning monetary amounts at which the elements of the FSs are to be recognised and reported The Framework acknowledges that a variety of measurement bases are used to different degrees and in varying combinations in FSs including: Historical cost Current replacement cost Net realisable value Present value (discounted expected future cash flow) 58
Measurement of the elements of FSs Historical cost: Is the measurement basis most commonly used today, but it is usually combined with other measurement bases Net realisable value: Is an asset s selling price or a liability s settlement amount 59 Measurement of the elements of FSs The Framework does not include concepts or principles for selecting which measurement basis should be used for particular elements of FSs or in particular circumstances After covering the objective of FSs, qualitative characteristics, and elements definitions, the Framework addresses measurement in only three paragraphs It is fair to say that this is a significant deficiency in the Framework 60