Financial Reporting

The Framework for IFRS

Students studying Financial Reporting papers will often come across the IASB’s ‘Framework Document’. Lots have been written about accounting standards and their principles, but what exactly is the IASB’s Framework Document.

The objective of the Framework Document is to set out the concepts that underlie the preparation and presentation of financial statements for external users as set out in the ‘Framework for the Preparation and Presentation of Financial Statements’. It is important at the outset to understand that the Framework Document itself is not a standard – its primary purpose is to assist the IASB in developing new or revised accounting standards and to assist preparers of financial statements applying accounting standards and dealing with issues which are not covered by accounting standards.

It covers:

the objectives;
the underlying assumptions;
the qualitative characteristics;
the elements of financial statements; and
the concepts of capital and capital maintenance.

THE OBJECTIVES

The objective of financial statements is to provide information about:

the financial position;
the financial performance; and
changes in financial position

of a reporting entity that is useful to a wide range of users in making economic decisions. If we consider how the above are reported within the financial statements:

The financial position = the statement of financial position (previously the balance sheet)

The financial performance = the statement of comprehensive income (previously the income statement)

The changes in financial position = the statement of cash flows (previously the cash flow statement)

The Financial Position

The financial position of an entity is affected by:

(a) the economic resources it controls;
(b) its financial structure;
(c) its liquidity and solvency; and
(d) the entity’s capacity to adapt to change.

The Financial Performance

The financial performance (primarily profitability) can be assessed to:

(a) predict the opportunity to generate cash flows from the resources the entity controls; and
(b) to form judgements above how the resources employed by the entity are effective.

Changes in Financial Position

These can be used to assess the investing, financing and operating activities as well as evaluating the entity’s ability to generate cash and cash equivalents. In addition to evaluating the entity’s ability to generate cash and cash equivalents, the changes in financial position can also be assessed to see how the entity uses those cash flows.

THE UNDERLYING ASSUMPTIONS

There are two fundamental terms which you will come across during your financial reporting studies. These terms are:

(a) the accruals basis of accounting; and
(b) the going concern basis.

The Accruals Basis

The accruals basis of accounting stipulates that an entity should recognise the effects of transactions and other events when they occur and not when they are paid or when cash is received in settlement.

In addition, an entity should also recognise these transactions and events in the financial statements in the period to which they relate. Consider the following example:

Ian Lucas Security Shutters Inc has a reporting date of 31 December. It receives a rent demand on 15 December for the period 1 January to 31 March. If Ian Lucas Security Shutters were to include this rent demand in its financial statements to 31 December, then this would distort the financial statements. The reason the financial statements would be distorted is because the period the rent demand relates to falls within the next financial year (1 January to 31 March). If it includes this invoice within the accounting system, then a prepayment of the full amount of the rent demand should be made to carry forward the demand to the next reporting period.

Conversely, if the rent demand related to 1 October to 31 December but was received on 10 January then the financial statements should include this amount as it relates to the financial year in question.

By complying with the accruals concept ensures that the financial statements inform users of obligations to pay cash in the future and also inform users of the entity’s obligations to also receive cash in the future.

The Going Concern Basis

If financial statements are prepared on a going concern basis, this assumes that the entity will continue in operation for the foreseeable future. This informs the user that the entity neither intended to liquidate or materially curtail the scale of operations.

THE QUALITATIVE CHARACTERISTICS

There are four qualitative characteristics which the IASB’s Framework Document refers to. They are:

(a) understandability;
(b) comparability;
(c) relevance; and
(d) reliability

Understandability and comparability are both ‘presentation’ issues within a set of financial statements. Relevance and reliability are both ‘content’ issues.

Understandability

Users of financial statements are assumed to have a good understanding of the business which the financial statements relate to as well as its activities. The users are expected to have a knowledge of financial issues, and information about complex matters should not be excluded simply because the entity may consider it too complex for certain users to understand.

Comparability

Users of financial statements must be able to compare financial statements of an entity to different entities in order to evaluate the financial position, performance and changes in financial position.

In addition, users should also be able to compare the financial statements of an entity through time i.e. from one year to the next, therefore financial statements must show corresponding information for preceding periods (these are often referred to as ‘comparatives’).

In order for comparability to be achieved, if an entity changes an accounting policy this is the reason why a prior year adjustment needs to be undertaken. This ensure consistent measurement and display of the financial effect of like transactions and other events.

Relevance

Information must be relevant in both nature and materiality. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Relevance could also be determined by nature alone. Consider this example:

Smyth Inc sold Blythe Inc an item of plant for $20 million. The fact that the director of Smyth Inc is the controlling director of Blythe Inc is another piece of information. The second piece of information is covered by IAS 24 ‘Related Parties’.

Reliability

For financial statements to be reliable they need to be free from material error and bias. In addition, they should demonstrate faithful representation, prudence and completeness. Completeness should be within the margins of cost and materiality but taking into consideration that an omission could cause information to be false or misleading resulting in unreliability.

Transactions within a set of financial statements should relate to their ‘substance’ rather than their legal form. This is particularly important when it comes to deciphering the treatment of leases (IAS 17 ‘Leases’), goods on consignment (IAS 18 ‘Revenue’) and financial instruments (IAS 39 ‘ Financial Instruments: Recognition and Measurement’).

ELEMENTS OF FINANCIAL STATEMENTS

The elements of the financial statements are made up of the following:

(a) assets;
(b) liabilities;
(c) equity;
(d) income; and;
(e) expenses

Assets
An asset is a resource controlled by the entity as a result of past events from which future economic benefits are expected to flow.

Remember, ‘control’ means the ability to restrict the use of the asset – for example inventory could be stored in a locked warehouse. In contrast, if an entity has a highly skilled workforce then it cannot recognise these as an asset because the entity cannot ‘control’ its workforce – they could leave at any time.

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

For example, future repairs and renewals cannot be recognised at the reporting date because there is no present obligation.

Equity
Equity is the residual interest in the assets of the entity after deducting all its liabilities.

Income
Income is increases in economic benefits during the reporting 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.

Income can include revenue and gains even though they may be included in equity rather than the statement of comprehensive income (for example a revaluation surplus).

An example of a contribution from equity participants is the purchase of additional shares.

Expenses
Expenses are decreases in economic benefits during the reporting period in the form of outlows (or depletions) of assets or incurrences of liabilities that result in decreases in equity other than those relating to distributions to equity participants.

CONCEPTS OF CAPITAL AND CAPITAL MAINTENANCE

There are two concepts of ‘capital’. There is the ‘financial’ concept and there is the ‘physical’ concept.

Financial Concept
The financial concept of capital is synonymous with the net assets or equity of the entity.

It works on the basis that profit is earned only if the financial amount of the net assets at the end of the period is in excess of the financial amount of net assets at the beginning of the period after excluding any distributions to, or contributions from, the owners during the period.

Physical Concept
The physical concept is regarded as the productive capacity of the entity based on operating capability.

It works on the basis that profit is earned only if the physical productive capacity of the entity at the end of the period is in excess of the physical productive capacity at the beginning of the period after excluding any distributions to, or contributions from, the owners during the period.

Conclusion

The IASB’s Framework Document underpins the preparation and presentation of financial statements. It is also important that students understand that if there is ever a conflict between the Framework Document and an accounting standard, then the accounting standard prevails.

Steve Collings FMAAT ACCA DipIFRS is Audit Manager at Leavitt Walmsley Associates (http://www.lwaltd.com) and a partner in AccountancyStudents.