(Solution Manual) Financial Accounting and Reporting An International Approach (European Edition)

Deegan, Ward, 1

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Author(s): Deegan, Ward

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Solutions Manual Financial Accounting and Reporting 1e by De egan and Ward Copyright © 2013 McGraw -Hill Ltd 1–1 PART 1: THE ACCOUNTING ENVIRONMENT Chapter 1 An overview of the external reporting environment Review questions 1.1 In most European countries there are three sources of regulation for accounting within companies. 1. Company legislation (influenced by European Union Directives) 2. Stock exchange requirements and 3. The Accountancy Profession typically on a national level by National Accounting Standard Setting Bodies. Over the past decade much convergence in accounting has been achieved, particularly within Europe, due to the support by the EU of the International Accounting Standards Board’s (IASB) work to produce a set of international financial reporting standards that promote consistency of treatment not only within but also across countries. This aims to support comparability, reduce costs for companies and to make capital more mobile. As mentioned, the IASB issue global accounting standards. The IASB is described on their website as ‘an independent standard -setting body of the IFRS Foundation’. The IASB is appointed and overseen by the IFRS Foundation Trustees, whom are publicly accountable to the Monitoring Board of public capital authorities. The IASB is very open with its deliberations, making all correspondence, details of meetings and deliberations availab le to the public and invites comment from a variety of stakeholders when publishing standards including investors, analysts, regulators, business leaders, accounting standard -setters and the accountancy profession. At the time of writing the IASB supporte d 29 International Accounting Standards (Standards originally issued before 2001 were called International Accounting Standards) and thirteen International Financial Reporting Standards (IFRSs) have been produced by the IASB, though at the time of writing only 9 were applicable. Four standards, namely IFRS 10 Consolidated Financial Statements , IFRS 11 Joint Arrangements, IFRS 12 Disclosure of Interests in Other Entities and IFRS 13 Fair Value will become effective on the 1 January 2013 – early adoption is p ermitted. The IASB is also currently updating the Conceptual Framework. The IASB has two main sub groups, the SME Implementation Group and the IFRS Interpretations Committee. 1.2 The auditor acts as an independent reviewer of the financial statements pr esented by a reporting entity. Being independent, the auditor is expected to provide an objective assessment as to whether, in the auditor’s opinion, the financial statements have been prepared in conformity with the various accounting and other reporting rules applicable to the reporting entity. The auditor, in a sense, provides greater credibility to the financial statements and allows financial statement users to rely upon the statements with greater confidence. With greater confidence, the financial sta tement users may attribute lower risk to a reporting entity, and this in turn may translate to the reporting entity being able to attract funds at a lower cost than may otherwise be possible. Hence, although the reporting organisation will have to pay for the audit, the benefits of attracting greater funds at a lower cost (because of a perception that the information about the organisation is more reliable or credible) might more than offset the costs associated with the audit. In this regard it should Solutions Manual Financial Accounting and Reporting 1e by De egan and Ward Copyright © 2013 McGraw -Hill Ltd 1–2 be n oted that prior to the introduction of legislation which required certain forms of organisations to have their financial statements audited, many organisations chose to have their financial statements audited because of the perceived benefits. Where there are perceived conflicts of interest between different parties within the organisation (for example, between owners and managers) the auditor can act to arbitrate on the reasonableness of the accounting rules and assumptions adopted by the managers. With th is said, it should also be emphasised that an unqualified auditor’s report (that is, a report that does not indicate any departure from accepted or mandated accounting procedures) does not give assurance that all transactions have been correctly accounted for, or that the entity is assured of being viable in the future. Also, it is conceivable that the credibility of all audit firms will not be deemed to be the same, such that if financial statement users consider that an auditor is of low ‘quality’ then an audit report produced by such an auditor may be of limited value. Lastly, it should be stressed that the preparation of the financial statements is the responsibility of management and the auditor will not make any changes to those reports: the auditor’s role is to give an opinion on the statements (for example, that they are true and fair and comply with applicable accounting s tandards). 1.3 This question may be answered in terms of a ‘free -market’ versus a ‘pro -regulation’ perspective about the provision of accounting information. Many academics argue in favour of a free -market approach. By this, we mean that there is a belief the market forces of supply and demand should be allowed to freely operate to determine the equilibrium amount of accounting infor mation to be provided. It is considered in this argument that if the users of accounting reports demand information but it is not being supplied, then this will be priced in to the amount they will charge the firm for the factors of production they supply to the firm (for example, equity capital). If an individual is able to obtain the demanded information then this may lead them to reduce the risk they attribute to the investment, which may translate to a lower required return on their investment. In a sen se, the price they pay for the information is the reduction in required return they demand as a result of being provided with the information (which reduced their risk). The firm is predicted to supply information to the point where the benefits of providi ng the information (perhaps in terms of lower cost of capital) equals the costs of providing the information (which of course assumes that the managers of an organisation have quite a sophisticated grasp of market economics). It has also been argued by proponents of the free -market argument that because there will often be conflict between the various parties associated with an organisation (for example, owners and managers) then accounting reports will be produced which are designed to minimise the conflic t and the associated costs of the conflict. It has also been argued that managers are best placed to select accounting methods that best reflect the financial performance and position of their particular organisation, and hence it is inappropriate and inef ficient to impose regulation upon them which restricts the accounting methods they might choose to use. There is also an argument that in the absence of regulation, organisations would still be inclined to disclose information in case various external part ies construe that the entity has something to hide (the ‘market for lemons’ argument). Advocates of a regulated approach would, by contrast, argue that a free market approach is flawed for a number of reasons. Firstly, the producers of the information cann ot typically control its dissemination. Parties, such as competitors, analysts and the like, will obtain the information, but will not directly pay for it (they are deemed to be ‘free -riders’). The free - rider problem may, in an unregulated environment, lea d to a reduction in the supply of Solutions Manual Financial Accounting and Reporting 1e by De egan and Ward Copyright © 2013 McGraw -Hill Ltd 1–3 information due to an understatement of demand. Further, although in the long run market forces may operate, it may be that organisations have created significant social costs in the meantime. For example, the disclosure o f environmental information within annual reports —that is, pollution emissions, clean -up costs , etc.—is not currently required in Australia. Research evidence, however, suggests that there are many financial statement users who may be interested in such in formation (for example, to assess the appropriate risk rates). It may be that sooner or later the market will punish those firms that do not provide information (in the absence of information the market may assume that there is bad news to report); however , significant costs may have been imposed on society by this time. The ‘free -market’ approach to financial reporting also ignores issues associated with stakeholders’ ‘right -to-know’ about certain aspects of an entity’s operations. Stakeholders without fin ancial resources (and perhaps the ‘power’ to demand financial information) may simply be ignored in the information dissemination process, yet they may nevertheless be affected by the operations of the organisation. Introducing regulation might also have t he effect of increasing confidence in the capital markets, which might be construed as being in the ‘public interest’. 1.4 The existence of this differential reporting requirement for small and large proprietary companies is based on the assumption that th e limited number of parties with a material interest in ‘small’ companies would conceivably be able to request information to satisfy their specific needs. However, it is assumed that the majority of stakeholders in ‘large’ companies do not have this abili ty. As organisations become larger there tends to be greater separation between ownership and management (or, as this is often termed, between ownership and control) and owners tend to become more reliant on external reports in order to monitor the progre ss of their investment. Further, as an entity increases in size, its economic and political importance increase, and in general this increases the demand for financial information about the entity. Also, requiring small organisation to fully implement IFRS s imposes a disproportionate burden on them in a situation where the benefits associated with the extensive disclosures do not necessarily exceed the costs . In part, this has been addressed in recent years by the IFRS for SMEs - a separate IFRS (most rec ent revision - July 2009) to cater for the needs of smaller entities that deem full IFRSs to be too onerous and inappropriate for their needs. In defining a SME the IASB does not use a benchmark size typology like that used in the UK, instead it defines S ME in terms of its public accountability, wherein a SME is an entity that does not have public accountability. The IFRS for SMEs is based on the same principles as full IFRS, however, contains certain omissions, simplifications, reduced disclosures and has been written for clarity. 1.5 Generally accepted accounting procedures (GAAPs) are those rules and practices that have changed and developed over time and are accepted at a point of time by the majority of accountants. Across time, generally accepted acco unting practices become incorporated within accounting standards, with accounting standards being developed through a consultative process in which many parties from Europe and elsewhere give their viewpoints through formal submissions and other avenues. A ccounting standards constitute a subset of GAAPs. Solutions Manual Financial Accounting and Reporting 1e by De egan and Ward Copyright © 2013 McGraw -Hill Ltd 1–4 1.6 A Directors' Report is recommended by the EU's Accounts Modernisation Directive (2003/51/EC) which is incorporated to European countries national legislation. In the UK the Directors' Report typically c ontains more information to that required by the Directive. In general the Directors' Report provides details on the state of the company and how it has complied with accounting regulation and its social responsibilities. Specifically, the Directors' Repo rt should contain the names of the directors and provide an outline of the company's principal activities. It should detail how the directors have discharged their responsibility to promote the success of the company and maintaining its business reputation for the long -term benefit of the company's shareholders, employees, the environment and the community. It should also provide an analysis of the business developments over the past year and outline a fair view of the risks and uncertainties that the compa ny faces. Large companies also need to provide a review of the business and Plcs have to provide additional information about business trends, the impact of the company on the environment, on employees and any contractual arrangements with customers or s uppliers that are essential to the company. The information provided on the business review and business trends, etc should include key performance indicators. Directors also need to explain their financial statements as part of their business review. In many instances legislation requires the auditor to provide assurance that the Directors' Report is not inconsistent with the financial statements and a country’s legislation may even allow the company to sue the directors personally for making false or mi sleading statements in the Directors' Report. 1.7 The ‘true and fair’ requirement is a qualitative reporting requirement. A current problem is that our qualitative requirement to present true and fair financial statements is very unclear as there is no de finitive explanation of what it means. There is no legal definition of ‘true and fair’. Even though legislation regularly requires directors to make sufficient disclosures to ensure that financial statements present a ‘true and fair’ view, it provides no d efinition of the concept. It is generally accepted that it would be unrealistic to assume that specific disclosure rules or accounting standards could be developed to cover every possible transaction or event. For situations not governed by particular rule s or standards, the ‘true and fair view’ requirement is the general criterion to assist directors and auditors to determine what disclosures should be made and to consider alternative recognition and measurement approaches. Although there is typically no definition of ‘true and fair’ in legislation —which is perhaps somewhat surprising —it would appear that for financial statements to be considered true and fair, all information of a ‘material’ nature should be disclosed so that readers of the financial statements are not misled. Also, there would be a general assumption that the financial statements comply with the relevant accounting standards and other generally accepted accounting principles. However, ‘materiality’ is an assessment calling for a high degre e of professional judgment. 1.8 The process for developing accounting standards is explained on the IASB’s website. The IASB releases International Financial Reporting Standards (IFRS). In developing an accounting standard the IASB often initially establis hes an Advisory Committee for a particular issue. The Advisory Committee provides advice on the issue to the IASB, after which time the IASB might decide to release a Discussion Document for public review and discussion. The Discussion Document might then be followed by an Exposure Draft, which Solutions Manual Financial Accounting and Reporting 1e by De egan and Ward Copyright © 2013 McGraw -Hill Ltd 1–5 would also typically be released for public comment (although sometimes they release a ‘staff draft’ which is not released for comment). Following this process the IASB might then release an IFRS. As can be seen, thr oughout the process of developing an IFRS there is generally plenty of scope for various stakeholders to voice their opinions about the issue. The AASB will provide direct input into the IASB’s accounting standard -setting process. For some topics it is to be anticipated that an accounting standard developed by the AASB might be used as a major basis for the development of an IFRS. Whether the views of the respective stakeholders are actually reflected in the final IFRS is an interesting issue (and there a re various theories that can be used to predict how the views of different stakeholder groups might be reflected in the final IFRS). Students should be encouraged to think about which stakeholder groups they believe would be most likely to influence (or ca pable of influencing) the accounting standard -setting process. 1.9 The International Financial Reporting Interpretations Committee is a committee of the IASB. It is the official ‘interpretative arm’ of the IASB. The IASB website states that the Internation al Financial Reporting Interpretations Committee (IFRIC) reviews, on a timely basis , accounting issues that are likely to receive divergent or unacceptable treatment in the absence of authoritative guidance, with a view to reaching consensus on the appropr iate accounting treatment. While IFRIC provides guidance on issues not specifically addressed in IFRS, it also provides Interpretations of requirements existing within IFRS. The Interpretations cover both newly identified financial reporting issues not spe cifically addressed in IFRSs and issues where unsatisfactory or conflicting interpretations have developed, or seem likely to develop in the absence of authoritative guidance, with a view to reaching consensus on the appropriate treatment. Given that so ma ny countries have now adopted IFRS, a central objective of IFRIC is to achieve consistent Interpretations of IFRS by IFRS -adopters internationally. If IFRS were interpreted differently within each country, the purpose and benefits of promoting one set of global accounting standards would be diminished. Indeed, the aim of global uniformity in interpreting financial reporting requirements has meant that many national standard -setters have disbanded their own domestic Interpretations committees. 1.10 The ans wers to this question will vary depending on the country selected for discussion. Within the UK some of the IFRIC Interpretations have been adopted into UK GAAP. The full details of these can be found in Urgent Issues Task Force Information Sheet No. 88 (issued April 2010 by the Financial Reporting Council). In total 7 of the IFRIC Interpretations have been reissued as UITF abstracts with the remaining IFRIC Interpretations not being adopted either because they have not been considered by the ASB (the UK na tional accounting standard setters) to be an issue that requires a UK abstract or the content of the IFRIC Interpretation is already contained within a UK issued Financial Reporting Standard or the UK accounting guidance is adequate. 1.11 The functions of the IASB are described on pages 8 to 12 of the textbook as well as on the IASB’s website. The IASB’s website states: In March 2001, the International Accounting Standards Committee (IASC) Foundation was formed as a not -for-profit corporation incorporate d in the State of Solutions Manual Financial Accounting and Reporting 1e by De egan and Ward Copyright © 2013 McGraw -Hill Ltd 1–6 Delaware, US. The IASC Foundation is the parent entity of the International Accounting Standards Board, an independent accounting standard -setter based in London, UK. On 1 April 2001, the International Accounting Standards Board (IASB) as sumed accounting standard -setting responsibilities from its predecessor body, the International Accounting Standards Committee. This was the culmination of a restructuring based on the recommendations of the report Recommendations on Shaping IASC for the F uture . The IASB structure has the following main features: the IASC Foundation is an independent organisation having two main bodies, the Trustees and the IASB, as well as a Standards Advisory Council and the International Financial Reporting Interpretatio ns Committee. The IASC Foundation Trustees appoint the IASB members, exercise oversight and raise the funds needed, but the IASB has sole responsibility for setting accounting standards. The International Accounting Standards Board is an independent, priva tely- funded accounting standard -setter based in London, UK. The Board members come from many countries and have a variety of functional backgrounds. The IASB is committed to developing, in the public interest, a single set of high quality, understandable a nd enforceable global accounting standards that require transparent and comparable information in general purpose financial statements. In addition, the IASB co -operates with national accounting standard -setters to achieve convergence in accounting standar ds around the world. As of July 2012 there were 15 Board members, each with one vote. The Trustees appoint the Board members. The IASC Foundation Constitution (as revised December 2010) provides that: The main qualifications for membership of the IASB sha ll be professional competence and practical experience. The Trustees shall select members of the IASB, consistently with the Criteria for IASB Members set out in the Annex to the Constitution, so that it will comprise a group of people representing, within that group, the best available combination of technical expertise and diversity of international business and market experience in order to contribute to the development of high quality, global accounting standards. The members of the IASB shall be requir ed to commit themselves formally to acting in the public interest in all matters. No individual shall be both a Trustee and an IASB member at the same time. [Paragraph 25] The Trustees shall select IASB members so that the IASB as a group provides an appr opriate mix of recent practical experience among auditors, preparers, users and academics. [ Paragraph 27 ] As it develops International Financial Reporting Standards, the IASB follows a rigorous, open due process . In commenting on the structure of the IASB, the website states: The structure is designed to support those features that are regarded as desirable in establishing the legitimacy of a standard -setting organisation: its member s are technically expert, represent the wider community and are independent. Solutions Manual Financial Accounting and Reporting 1e by De egan and Ward Copyright © 2013 McGraw -Hill Ltd 1–7 The structure achieves its purpose by a balance of the functions of the various parts of the organisation, through the operational relationship shown in the diagram. The compositi on of the oversight body (the Trustees of the International Accounting Standards Committee Foundation), the advisory body (the Standards Advisory Council) and the interpretative body (the International Financial Reporting Interpretations Committee) represe nts the wider community by reflecting a diversity of geographical or professional backgrounds and membership of the standard -setting body (the International Accounting Standards Board) is based on the principles of technical competence and independence. 1.12 There are a number of potential impediments to the international standardisation of accounting standards , including: • Harmonisation or standardisation requires the release of many exposure drafts, new accounting standards, and the revision of many existi ng accounting standards . This in itself is very costly. However, there are many other ‘indirect’ costs. For example, preparers must learn the new rules, as must readers (including analysts and regulators). The costs for a company to switch to IFRS can be s ignificant and could be an impediment to a country embarking on a process of harmonisation. • To date, there is limited empirical support for the view that standardising domestic accounting s tandards with International Financial Reporting Standards will actu ally lead to inflows of foreign capital. Without such evidence, various parties within a particular country may be less inclined to support the standardisation process. • A great deal of existing research has sought to explain international differences in accounting standards on the basis of differences in cultures between countries (although as countries embrace IFRS these differences obviously decline) . That is, culture seems to explain international variation in accounting standards . For example, some coun tries may have cultures that are inclined towards secrecy (and therefore, limited disclosures), whereas other countries may have cultures inclined towards transparency (and therefore greater disclosures). To impose the same accounting s tandards on all (wit h a particular level of disclosure) ignores these cultural differences and may, in the long run, provide a reason why standardisation may be more successful in some countries than others. 1.13 This is a very interesting issue. As we could appreciate, the d ecision by the EU would have resulted in great costs to European business in terms of learning about new accounting requirements and in changing accounting systems so as to accommodate the new requirements. Whether the associated benefits exceeded the cost s is a difficult issue to support one way or the other. There is a general view held by bodies such as the IASB that it is preferable that every country ultimately should have the same accounting s tandards in place. This will make international comparison of performance easier. There is also a view that international standardisation will increase the inflow of foreign capital. (Is this a reasonable assumption that is supported by any empirical evidence?) Another view is that the process will reduce the repo rting costs of European companies that are required to provide reports to foreign jurisdictions. 1.14 There were many significant changes as a result of Europe adopting IFRS. These changes had a significant impact on profits and assets in some entities. Given the magnitude of the impact of adopting IFRSs on corporate financial statements, it would have been useful for Solutions Manual Financial Accounting and Reporting 1e by De egan and Ward Copyright © 2013 McGraw -Hill Ltd 1–8 reporting entities to tell financial statement readers, in advance, about the consequences of adopting IFRSs for subsequent corporate financi al performance and financial position reporting. This would have reduced the ‘shocks’ that were felt when the IFRS -compatible financial statements were first applied. To assist companies when first adopting IFRS the IASB issued IFRS 1 First -time Adoption of International Financial Reporting Standards . This standard provides guidance for entities adopting IFRS for the first time. In particular it requires that entities disclose the effect of the transfer to IFRS on an entity’s reported financial position, f inancial performance and cash flows. This information should be of benefit to users who wish to make economic decisions based on the information supplied in financial statements. Challenging questions 1.15 (a) One motivation for providing a set of figur es using a preferred -accounting approach is that management may honestly believe that the particular accounting requirements embodied within a particular accounting s tandard are not appropriate to a particular entity, and that they do not allow management to appropriately report its entity’s performance and financial position. Alternatively, management may seek to provide a separate set of figures to highlight a result that is favourable. In practice, differentiating between the various motivations may not be an easy task. (b) The approach adopted by ABC is not, strictly speaking, in contravention of the Companies Act which requires the directors to add such information and explanations as will give a true -and-fair view. If directors maintain that the additi onal information is necessary to give a true and fair view then they are not in contravention of the law. (this answer is relevant to legislation in the UK and in the ROI) However, they could appear to be emphasising, inappropriately, particular figures over and above those that would be generated with the adoption of the applicable accounting s tandards. 1.16 Answers vary with years and company chosen. 1.17 There have been several key changes in financial reporting regulation that reflect a movement away f rom self -regulation by the accounting profession to a government - regulated model. In the past the profession organised their own self -regulation and through this developed and issued standards. The source of regulation has changed with accounting standard setting bodies being accountable to independent bodies that may have government input. For example, in the UK the ASB (national standard setting body) reports to the FRC, whose members are appointed directly or indirectly by the Treasurer (Government depa rtment) . 1.18 In Europe entities that are listed on recognised share exchanges must prepare financial statements using IFRS. Of these companies , those that are more likely to realise the proposed benefits [that follow from using IFRS] of comparability, r educed barriers, reduced reporting costs and reduced costs of capital are those companies that are listed on foreign securities exchanges, in Solutions Manual Financial Accounting and Reporting 1e by De egan and Ward Copyright © 2013 McGraw -Hill Ltd 1–9 particular exchanges in countries that have also adopted international financial reporting standards; companies fo llowed by analysts; and companies with subsidiaries in countries using international financial reporting standards. 1.19 This is a question that has been asked to stimulate debate. There is no absolute answer. Students should consider whether it does make sense to encourage all countries of different cultures, histories and religions to conform with particular corporate disclosure regulation when there is no expectation that there should be any form of global uniformity in corporations legislation or busin ess laws. Wouldn’t uniformity of business laws also help the international transfer of capital? For example, s hould the Danish government seek to change business law in Denmark so that it become s consistent with the law in other major trading nations, and should this happen even if the Danish think their rules are superior prior to any convergence? Or do we accept that cultural, religious, historical and other reasons preclude changing corporate laws when such impediments were not sufficient to stop the global push towards converging accounting regulations? Is there some lack of consistency here? 1.20 Proponents of a free -market perspective on accounting regulation typically believe that accounting information should be treated like other goods, with demand and supply forces being allowed to operate to generate an optimal supply of information about an entity. In support of this view it is argued that: • Even in the absence of regulation, there are private economics -based incentives for the organisation to prov ide credible information about its operations and performance to certain parties outside the organisation, otherwise the costs of the organisation’s operations would rise. This view is based on a perspective that the provision of credible information allow s other parties to monitor the activities of the organisation. Being able to monitor the activities of an entity reduces the risk associated with investing in the entity, and this in turn should lead to a reduction in the cost of attracting capital to the organisation. • It has also been argued that there will often be conflicts between various parties with an interest in an organisation, and accounting information will be produced, even in the absence of regulation, to reduce the effects of this conflict. • If an entity that borrows funds also agrees to provide regular financial statements to the providers of the debt capital (the debt holders ), this ability to monitor the financial performance and position of the borrower will reduce the risks of the lender. This should translate to lower costs of interest being charged and hence provide an incentive for the borrower to provide financial statements even in the absence of regulation. • Managers of the organisation will be best placed to determine what information should be produced to increase the confidence of external stakeholders that the information being presented reflects the financial position and performance of a reporting entity (thereby decreasing the organisation’s cost of attracting capital). Regulatio n that restricts the available set of accounting methods will decrease the efficiency with which information will be provided. This in turn leads us to question whether the ‘one -size- fits-all’ assumption inherent in the requirement that all entities apply the same accounting standards is applicable or appropriate in all circumstances particularly where there are major differences between the various organisations applying the accounting standards. Solutions Manual Financial Accounting and Reporting 1e by De egan and Ward Copyright © 2013 McGraw -Hill Ltd 1–10 • Certain mandated disclosures will be costly to the organisat ion if they enable competitors to take advantage of certain proprietary information. • Even in the absence of regulation, external parties would demand that financial statement audits be undertaken. If such audits are not undertaken, financial statements would not be deemed to have the same credibility and, consequently, less reliance would be placed on them. If reliable information is not available, the risk associated with investing in an organisation might be perceived to be higher, and this could lead to increases in the cost of attracting funds to the organisation. • In the absence of regulation, organisations would still be motivated to disclose both good and bad news about an entity’s financial position and performance. Such a perspective is often refer red to as the ‘market for lemons’ perspective (Akerlof 1970), the view being that in the absence of disclosure the capital market will assume that the organisation is a ‘lemon’. That is, no information is viewed in the same light as bad information . Hence, even though the firm might be worried about disclosing bad news, it is assumed that the market might make an assessment that silence implies that the organisation has very bad news to disclose (otherwise, it would disclose it). This ‘market for lemons’ pe rspective provides an incentive for managers to release information in the absence of regulation, as failure to do so will have its own implications for the organisation. That is, ‘non -lemon owners have an incentive to communicate’ (Spence 1974, p. 93). 1.21 The international standardisation of financial reporting does assume that a ‘one -size-fits-all’ approach is appropriate. That is, it assumes that globally, a ll users of financial statements have the same demands and expectations in relation to financial information. This does seem to be somewhat naïve and does ignore a great deal of literature that suggests that different cultures have different information demands and expectations. A number of researchers have explicitly questioned the relevance of ‘Wes tern-style’ standards to the needs of people within developing countries, or the relevance of ‘Anglo -American’ standards in ‘continental European’ countries. Is it really appropriate, for example, that a manufacturing organisation in China , adopt the same accounting standards as a service organisation in Europe ? Also, is it really appropriate that a Chinese producer of steel shall use the same use the same accounting standard to account for inventory as would a European car manufacturer? This will be a matt er of opinion, but are these two ‘inventories’ that similar? Are the information requirements of users the same despite the nature of the inventories or the institutional environments being so different? Further, accounting standards are expected to foster comparability on an international basis between different entities - but how often would we want to compare the inventory of a European car manufacturer with a steel producer in China? Efforts, by organisations such as the IASB, to standardise internationa l financial reporting also assumes that different countries will employ the same enforcement mechanisms - and this is also somewhat naïve. If countries have differing levels of enforcement with respect to IFRSs then it is misleading to suggest that we can achieve international standardisation given that lack of enforcement means that countries (and companies) can state that they have complied with IFRS when this might not the case. Global standardisation would require standardisation of corporate laws as th ey relate to compliance with accounting standards - and such standardisation of regulatory bodies would be unlikely . (It should be remembered that whilst the IASB develops accounting standards, it has no power to enforce their application. Enforcement is a local issue .) Solutions Manual Financial Accounting and Reporting 1e by De egan and Ward Copyright © 2013 McGraw -Hill Ltd 1–11 1.22 There are various arguments ‘for’ and ‘against’ the international standardisation of financial reporting. Arguments for include: • International investors are better able to understand the financial performance and position of local compa nies. • Tied to the above point, there is an expectation that standardisation will facilitate greater capital inflows. • Also tied to the above point, standardisation will make it easier for local companies to list on foreign stock exchanges. • Companies listed on several security exchanges would only need to produce one set of financial statements and this will have implications for cost savings. • The accounting and auditing staff employed by international organisations will be better able to move to other member companies, and this will have implications for the efficient operations of an entity. • There will be cost savings in the accounting -standard setting function. Rather than individual countries duplicating the efforts of other countrie s, the majority of functions of the standard -setting process will be centralised at the IASB which is headquartered in London . Arguments against include: • All convergence and standardisation benefits will come at a cost. Such costs include the costs of educating accountants to a dopt a new set of accounting standards and the costs associated with changing data -collection and reporting systems. Such costs will be borne by large listed companies, as well as large proprietary companies, not -for- profit entities and local governments. These last three categories of reporting entities are relatively unlikely to benefit from such things as increased capital inflows. Yet they will still incur significant costs • International differences in culture bring into question the relevance of IFRS a cross all countries. Perera (1989, p. 43) argues that culture is a powerful environmental factor affecting the accounting system of a country and, therefore, that accounting cannot be considered to be ‘culture free’. Perera (1989) argues that IFRSs themsel ves are strongly influenced by Anglo -American accounting models and, as such, International Accounting Standards tend to reflect the circumstances and patterns of thinking in a particular group of countries. He argues therefore that IFRSs are likely to enc ounter problems of relevance in countries with different cultural environments from those found in Anglo -American countries. • It is misleading to indicate that there is global standardisation of financial reporting when there are differences in enforcement mechanisms across countries. For example, do we expect compliance with IFRSs to be enforced equally by German regulators and regulators in poor, developing countries? Nevertheless, organisations in these countries might all state that they have adopted IFR S (in many cases because of the reputation benefits associated with applying IFRS). In essence, there will not be standardisation despite statements indicating the contrary. Solutions Manual Financial Accounting and Reporting 1e by De egan and Ward Copyright © 2013 McGraw -Hill Ltd 1–12 1.23 Students should be encouraged to review a number of accounting standards to s ee for themselves whether there is a common format for presenting accounting standards. As they will see, whilst there is some variation in formats, a typical accounting standard will have the following sections: • Preface • Comparison with international prono uncements • Objective • Application • Scope • Definitions . Depending upon the issue being addressed within the particular accounting standard the accounting standard might also have sections addressing various recognition (and derecognition) and measurement issues , as well as possibly having sections addressing specific classification, presentation and/or disclosure issues. The standard might also include an Appendix with illustrative examples, and the ‘basis for conclusions’ that accompanied the development of the standard. 1.24 The EU considered that public limited companies would be disadvantaged if their financial statements were not considered to be comparable with the financial statements of companies around the globe and hence from 2005 EU Regulation 1606/20 02 require d that all companies listed on European securities exchanges comply with IFRS that have been endorsed by the EU when preparing consolidated financial statements (Pope and McLeay, 2011). Therefore, in each European country accounting regulation fo r Plcs is typically provided by legislation on their corporations/companies. For example, in the UK regulation is provided by the Companies Act 2006. Section 395 of this act gives companies the option of preparing their financial statements in accordance w ith the guidance provided in s396 of the Act or with IFRS. Arguments for harmonisation include: -Overall better quality standards (global input to the development process) -More comparable financial statements across the globe. -Reduced costs for mul tinational corporations (groups with subsidiaries in other countries) -Access to capital markets in other countries -Portable accounting expertise within groups -Improved understanding by investors of foreign companies -Improved ability of companies to identify and target potential takeovers Solutions Manual Financial Accounting and Reporting 1e by De egan and Ward Copyright © 2013 McGraw -Hill Ltd 1–13 Arguments against harmonisation include: -Difficult and costly to achieve. Being compliant may differ across countries as some countries may enforce compliance with rigour and other countries may not. -The be nefits of harmonization are not always accepted as outweighing the costs. -The cost of harmonization to entities is great in terms of additional training, accountancy and audit fees and systems may even need to be changed. - Many cultural, economic and po litical differences across countries may result in different interpretations of accounting standards. Global accounting standards are not tailored to suit country specific norms. Solutions Manual t/a Financial Accounting and Reporting by Deegan and Ward Copyright © 201 3 McGraw -Hill Australia Pty Ltd 2–1 Chapter 2 The conceptual framework of accounting and its relevance to financial reporting Review questions 2.1 A conceptual framework is a coherent system of interrelated objectives and fundamentals that is expected to lead to consistent standards (FASB - see page 46). . 2.2 The term general purpose financial statements refers to financial statements that comply with the conceptual f ramework, accounting standards and other generally accepted accounting principles and are released by reporting entities to sa tisfy the information demands of a varied cross -section of users. These reports can be contrasted with special purpose financial statements, which are provided to meet the information demands of a particular user or group of users. General purpose financia l statements are defined in as the IASB Conceptual Framework as “those financial statements intended to meet the needs of users who are not in a position to require an entity to prepare reports tailored to their particular information needs ”. 2.3 An entit y becomes a reporting entity when users are said to exist who do not have access to information relevant to decision making and who are judged to be dependent on general purpose financial reports (GPFRs) , the entity is deemed to be a reporting entity Gene ral purpose financial statements should be prepared when there are users whose information needs have common elements, and those users cannot command the preparation of information to satisfy their individual information needs. If an entity is not deemed t o be a ‘reporting entity ’ then it will not be required to produce GPFSs, nor will it necessarily be required to comply with all accounting standards. Whether an entity is classified as a reporting entity is determined by the extent to which users (of finan cial information relating to that entity) have the ability to command the preparation of financial statements tailored to their particular information needs. Such a determination depends upon professional judgment. When information relevant to decision making is not otherwise accessible to users who are judged to be dependent upon general purpose financial statements to make and evaluate resource -allocation decisions, the entity is deemed to be a reporting entity. Where dependence is not readily apparent, f actors that might indicate a reporting entity include the level of separation between management and owners and investors, the economic/political influence of the entity and the size of the entity in terms of its impact on employees, customers, suppliers e tc. 2.4 The first conceptual framework started to emerge in America in the 1970s. This framework focused on providing a framework which would produce accounting standards that, in theory, supply investors with information for investment decisions. These d ecisions being whether to buy or sell shares in an entity. The FASB completed its framework in 1985 and in 1989 the IASC adopted the framework in its Framework for the Preparation and Presentation of Financial Statements . The aims of the Framework were to help the IASC develop new international standards, to review existing standards to reduce the number of alternative treatments allowed, and to assist national standard -setting bodies in developing standards consistent with international standards. This Framework remained in place for many years but is currently being reviewed in a joint project by t he IASB and the FASB . The first phase of the joint IASB/FASB initiative was completed in September 2010 and the IASB Conceptual Framework was amended. It was renamed to become the Conceptual Framework for Financial Reporting . The October 2010 Solutions Manual t/a Financial Accounting and Reporting by Deegan and Ward Copyright © 201 3 McGraw -Hill Australia Pty Ltd 2–2 revised version of the Conceptual Framework includes the first two chapters that the IASB has published as a result of its first phase of the conceptual framework project, these being: • Chapter 1 The objective of financial reporting • Chapter 3 Qualitative characteristics of useful financial information . Chapter 2 of the Conceptual Framework , which has not yet been updated, will deal with the reporting entity concept. The IAS B published an exposure draft on the reporting entity concept in March 2010. Chapter 4 contains the remaining text of the original IASB Framework (1989). 2.5 Whether or not we need a conceptual framework is a matter of opinion. Also, what is included wit hin a conceptual framework will also be a matter of opinion. For example, we might not all agree on the stated objectives of general purpose financial reporting or on the qualitative characteristics that financial information should possess. Ideally we wou ld have had a conceptual framework prior to the development of accounting standards as this may have enabled the development of accounting standards that are consistent with one another. Also, if there is agreement on certain fundamental and key issues the n such issues would not need to be debated each time a new accounting standard is being developed. It is a costly process to develop a conceptual framework, and one which will require ongoing work. It should be noted that the development of the FASB’s firs t conceptual framework was very slow. Many of the issues or building blocks shown in Figure 2.1 on page 5 4 remain to be addressed. From 2005 most European countries adopted the IASB Framework. Ongoing work is being undertaken by the IASB and the FASB to develop a joint conceptual framework to be used internationally and in 2010 amendments were made and a new component of the framework was released. 2.6 In considering the matter of the level of expertise expected of financial statement readers, it has genera lly been accepted that readers are expected to have some proficiency in financial accounting. As a result, accounting standards are developed on this basis. The FASB Conceptual Fr amework had referred to the ‘informed reader ’. In the IASB Conceptual Framewo rk, as released in 2010, it is explained that: 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 use rs may need to seek the aid of an adviser to understand information about complex economic phenomena. Therefore, financial statements are not compiled for an audience that is not educated to some degree in the workings of accounting - this is an interesti ng observation given the many hundreds of thousands of financial statements being sent to investors annually, most of whom would have no grounding whatsoever in accounting. Students should be encouraged to consider whether it is reasonable to make this ass umption about perceived expertise. If this assumption was not made then what implications would this have for accounting standards and general purpose financial statements? Is there a realistic alternative to making this assumption? Solutions Manual t/a Financial Accounting and Reporting by Deegan and Ward Copyright © 201 3 McGraw -Hill Australia Pty Ltd 2–3 2.7 The IASB Conceptu al Framework defines income 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 equ ity participants. The Conceptual Framework draws a distinction between ‘revenues ’ and ‘gains ’. Income consists of both revenues and gains. Under the Conceptual Framework, ‘revenue ’ arises in the course of the ordinary activities of an entity and is referre d to by a variety of different names, including 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 course of the ordinary activities of an enterprise. Gains include, for example, those arising on the disposal of non -current assets or increases in the value of assets . Some gains, those that arose in the ordinary course of business are included in profit or loss and other unrealised gains, such as the upw ard revaluation of assets are included in ‘other comprehensive income’. Some measure of professional judgment will be involved in determining whether a component of income should be classified as ‘revenue ’ or as a ‘gain’. Prior to 2005, within some countri es in Europe , rather than referring to income reference was made to ‘sales’ and ‘other income’ and there was no statement of comprehensive income . Students should be encouraged to consider whether it is useful to subdivide income into revenues and gains. 2.8 Enhancing qualitative characteristics are complementary to fundamental qualitative characteristics. Enhancing qualitative characteristics distinguish more useful information from less useful information. The enhancing qualitative characteristics are c omparability, verifiability, timeliness and understandability. These characteristics enhance the decision - usefulness of financial reporting information that is relevant and faithfully represented . As paragraph QC 4 of 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. 2.9 According to the IASB Conceptual Framework , to be useful, financial information must not only represent relevant phenomena, but it must also ‘faithfully represent ’ the phenomena that it purports to represent. According to paragraph QC 12 of 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. Of course, perfection is seldom, if ever, achievable. The Board ’s objective is to maximise those qualities to the extent possible. In terms of the three characteristics of ‘complete ’, neutral ’ and ‘free from error ’, that together reflect faithful representation, paragraphs QC13, 14, and 15 of the IASB Conceptual Framework state: QC13 A complete depiction includes all inform ation necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations. For example, a complete depiction of a group of assets would include, at a minimum, a description of the nature of the assets in the group, a numerical depiction of all of the assets in the group, and a description of what the numerical depiction represents (for example, original cost, adjusted cost or fair value). QC14 A neutral depiction is without bias in the selection or present ation of financial information. A neutral depiction is not slanted, weighted, emphasised, de -emphasised Solutions Manual t/a Financial Accounting and Reporting by Deegan and Ward Copyright © 201 3 McGraw -Hill Australia Pty Ltd 2–4 or otherwise manipulated to increase the probability that financial information will be received favourably or unfavourably by users. Neutral informatio n does not mean information with no purpose or no influence on behaviour. On the contrary, relevant financial information is, by definition, capable of making a difference in users ’ decisions. QC15 Faithful representation does not mean accurate in all resp ects. Free from error means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. In this context, free from error does n ot mean perfectly accurate in all respects. For example, an estimate of an unobservable price or value cannot be determined to be accurate or inaccurate. However, a representation of that estimate can be faithful if the amount is described clearly and accu rately as being an estimate, the nature and limitations of the estimating process are explained, and no errors have been made in selecting and applying an appropriate process for developing the estimate. Hence, from the above paragraphs we should understan d that 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. Further, faithful representation does not mean total absence of error in the depiction of particular transactions, events or circumstances because the economic phenomena presented in financial statements are often, and necessarily, measured under conditions of uncertainty. Hence, most financia l reporting measures involve various estimates and instances of professional judgment. To faithfully represent a transaction or event an estimate must be based on appropriate inputs and each input should reflect the best available information. 2.10 Within the IASB Framework, the primary users of general purpose financial reports are deemed to be ‘investors, lenders and other creditors ’. As the IASB Framework (Chapter 1, paragraph OB5) states: Many existing and potential investors, lenders and other credito rs cannot require reporting entities to provide information directly to them and must rely on general purpose financial reports for much of the financial information they need. Consequently, they are the primary users to whom general purpose financial repo rts are directed. In the previous conceptual framework released by the IASB the ‘public ’ had been identified as a user of general purpose financial statements. However, in the IASB Conceptual Framework released in 2010, even though a primary group of users are identified, it is proposed that accounting information designed to meet the information needs of investors, creditors and other users will usually also meet the needs of the other user groups identified. As the IASB Conceptual Framework (Chapter 1, pa ragraph OB10) states: 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. However, those reports are not primarily directed to these other gr oups. In explaining the reasons why the users of financial statements were identified as primarily being investors, lenders and other creditors, the Basis for Conclusions that accompanied the release of the IASB Conceptual Framework stated: Solutions Manual t/a Financial Accounting and Reporting by Deegan and Ward Copyright © 201 3 McGraw -Hill Australia Pty Ltd 2–5 The reasons why the Board concluded that the primary user group should be the existing and potential investors, lenders and other creditors of a reporting entity are: (a) Existing and potential investors, lenders and other creditors have the most critical and immediate need for the information in financial reports and many cannot require the entity to provide the information to them directly. (b) The Board ’s and the FASB ’s responsibilities require them to focus on the needs of participants in capital markets, which incl ude not only existing investors but also potential investors and existing and potential lenders and other creditors. (c) Information that meets the needs of the specified primary users is likely to meet the needs of users both in jurisdictions with a corp orate governance model defined in the context of shareholders and those with a corporate governance model defined in the context of all types of stakeholders. Students should be encouraged to discuss whether they agree with the above depiction of users. In considering the matter of the level of expertise expected of financial statement readers, it has generally been accepted that readers are expected to have some proficiency in financial accounting. As a result, accounting standards are developed on this ba sis. The IASB Conceptual Framework , (Chapter 3, paragraph Q32) explains that: 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. So financial statements are written for an audience that is educated to some degree in the workings of accounting —this is a n interesting observation given the many hundreds of thousands of financial statements being sent to investors annually, most of whom would have no grounding whatsoever in accounting. To usefully consider the required qualitative characteristics financial information should possess (for example, relevance and understandability), some assumptions about the abilities of report users are required. It would appear that those responsible for developing conceptual frameworks have accepted that individuals without any expertise in accounting are not the intended audience of reporting entities ’ financial statements (even though such people may have a considerable amount of their own wealth invested). Again, students should be encouraged to discuss this assumption. 2.11 Directors must comply with accounting standards. Nevertheless, if directors believe that particular accounting standards are not appropriate, they have the option of highlighting this fact and explaining why. Specifically, paragraph 23 of IAS 1 Present ation of Financials Statements states: In the extremely rare circumstances in which management concludes that compliance with a requirement in an International Financial Reporting Standard would be so misleading that it would conflict with the objective of financial statements set out in the Conceptual Framework, but the relevant regulatory framework prohibits departure from the requirement, the entity shall, to the maximum extent possible, reduce the perceived misleading aspects of compliance by disclosing : (a) the title of the International Financial Reporting Standard in question, the nature of the requirement, and the reason why management has concluded that complying Solutions Manual t/a Financial Accounting and Reporting by Deegan and Ward Copyright © 201 3 McGraw -Hill Australia Pty Ltd 2–6 with that requirement is so misleading in the circumstances that it conflicts with the objective of financial statements set out in the Conceptual Framework; and (b) for each period presented, the adjustments to each item in the financial statements that management has concluded would be necessary to achieve a fair presentation. As we can se e from the above, IAS 1 includes a rebuttable presumption that if other entities in similar circumstances comply with the requirement, the entity ’s compliance with the requirement would not be so misleading that it would conflict with the objective of fina ncial statements set out in the IASB Conceptual Framework . 2.12 Previously, it was generally accepted that the IASB Conceptual Framework was not mandatory. However, accounting standards that have been adopted by the EU are and the inclusion of two paragrap hs in Accounting Standard IAS 8 Accounting Policies, Changes in Accounting Estimates, and Errors has changed this position so that preparers of general purpose financial statements are now required to follow the IASB Framework. Specifically, paragraphs 10 and 11 of IAS 8 state: 10. In the absence of an International Financial Reporting Standard that specifically applies to a transaction, other event or condition, management shall use its judgement in developing and applying an accounting policy that results in information that is: (a) relevant to the economic decision -making needs of users; and (b) reliable, in that the financial statements: (i) represent faithfully the financial position, financial performance and cash flows of the entity; (ii) reflect th e economic substance of transactions, other events and conditions, and not merely the legal form; (iii) are neutral, that is, free from bias; (iv) are prudent; and (v) are complete in all material respects. 11. In making the judgement described in paragra ph 10, management shall refer to, and consider the applicability of, the following sources in descending order: (a) the requirements and guidance in International Financial Reporting Standards dealing with similar and related issues; and (b) the definition s, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the IASB Conceptual Framework . Hence, the accounting standard IAS 8 requires management to refer to the IASB Conceptual Framework where a specific issue is not addressed in a particular accounting standard. That is, in the absence of a specific accounting standard to address an issue, reporting entities must be guided by the IASB Conceptual Framework . 2.13 Given the central importance of the definition of assets to financial reporting (the definitions of the other elements of accounting are based around the definition of assets), any change to it will conceivably have broad implications for financial reporting. In relation to joint work being undertaken by the FA SB and IASB, the FASB and IASB released a Project Update: Conceptual Framework —Phase B: Elements and Recognition in 2008 . After consulting Solutions Manual t/a Financial Accounting and Reporting by Deegan and Ward Copyright © 201 3 McGraw -Hill Australia Pty Ltd 2–7 technical experts, the Boards decided to consider the following working definition of an asset: An asset of an entity is a present economic resource to which the entity has a right or other access that others do not have. Whether the above definition replaces the existing definition of assets is something that will be revealed in future years. Certainly, the above defin ition seems to have some limitations of its own. Again, what we need to appreciate is that given that the definitions of other elements of accounting (equity, income and expenses) rely directly upon the definition of assets, any change to the definition of assets will potentially have very significant impacts on general purpose financial reporting. In relation to the current thinking on a revised liability definition, the IASB and FASB have suggested the following: A liability of an entity is a present eco nomic obligation for which the entity is the obligor. This proposed definition uses a number of key terms, specifically : present, economic obligation and obligor. The IASB and FASB have provided the following definitions of these key terms: • Present means that on the date of the financial statements both the economic obligation exists and the entity is the obligor. • An economic obligation is an unconditional promise or other requirement to provide or forgo economic resources, including through risk prote ction. • An entity is the obligor if the entity is required to bear the economic obligation and its requirement to bear the economic obligation is enforceable by legal or equivalent means. Again, as with the proposed change to the definition of assets, t he suggested change to the definition of liability could potentially have significant implications for financial reporting if it was ultimately incorporated within the revised conceptual framework. For example, the above definition could act to exclude con structive or equitable obligations that are not ‘enforceable by legal or equivalent means ’. This would be a major departure from existing practice. Further, and as with the definition of assets, any change to the definition of liabilities will potentially have very significant impacts on the expenses, income and equity of a reporting entity. Again, whether the above proposed definition ultimately becomes part of the revised conceptual framework is a matter for debate. 2.14 We do not need separate recogniti on criteria for equity. The Conceptual Framework defines equity as ‘the residual interest in the assets of the entity after deducting all its liabilities ’. The residual interest is a claim or right to the net assets of the reporting entity. As a residual interest, equity ranks after liabilities in terms of a claim against the assets of a reporting entity. Consistent with the definitions of income and expenses, the definition of equity is directly a function of the definitions of assets and liabilities. Give n that equity represents a residual interest in the assets of an entity, the amount disclosed as equity will correspond with the difference between the amounts assigned to assets and liabilities. As such, the criteria for the recognition of assets and liab ilities, in turn, directly govern the recognition of equity. That is, as equity equals assets minus liabilities, and as we have recognition criteria for assets and liabilities, then equity being the difference does not have to have specific recognition cri teria. Solutions Manual t/a Financial Accounting and Reporting by Deegan and Ward Copyright © 201 3 McGraw -Hill Australia Pty Ltd 2–8 2.15 It is preferable to have a well -developed conceptual framework prior to the development of accounting standards because: • Accounting standards would then be more consistent and logical, because they are developed from an orderly set of concepts. The view is that in the absence of a coherent theory, the development of accounting standards could be somewhat ad hoc. As the FASB and IASB (2005, p. 1) state: To be principles -based, standards cannot be a collection of conventions but rather must be roo ted in fundamental concepts. For standards on various issues to result in coherent financial accounting and reporting, the fundamental concepts need to constitute a framework that is sound, comprehensive, and internally consistent. • Increased international compatibility of accounting standards should occur, because they are based on a conceptual framework that is similar to that in other jurisdictions (for example, there is much in common between the IASB and FASB Frameworks). • The IASB should be more account able for their de cisions when developing accounting standards, because the thinking behind specific requirements should be more explicit, as should any departures from the concepts that might be included in particular accounting standards. • Having a concept ual framework should alleviate some of the political pressure that might otherwise be exerted when accounting standards are developed —the conceptual f ramework could, in a sense, provide a defence against political attack. • The development of accounting stan dards and other authoritative pronouncements should be more economical because the concepts developed within the conceptual framework will guide the IASB in their decision making. • Where accounting concepts developed within a conceptual framework cover a particular issue, there might be less need to develop additional accounting standards. 2.16 The elements of financial statements as per the Conceptual Framework are assets, liabilities, expenses, income and equity. See the text on pages 72 to 84 and the IASB Conceptual Framework for the definitions and recognition criteria of the various elements. 2.17 The recognition of assets, liabilities, income and expenses is dependent upon the following criteria: An item that meets the definition of an element should b e recognised if: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured with reliability. The determination of ‘probable ’ is central to the r ecognition criteria applied to the elements of financial statements. Unfortunately, however, the IASB Conceptual Framework does not define ‘probable ’. However, it is generally accepted that probably means ‘more likely rather than less likely ’. A transactio n or event needs also to be capable of reliable measurement before it is recognised for financial reporting purposes. This does not require that there must be certainty in relation to the measurement, because in practice there are many transactions Solutions Manual t/a Financial Accounting and Reporting by Deegan and Ward Copyright © 201 3 McGraw -Hill Australia Pty Ltd 2–9 involvi ng estimations that cannot be measured with certainty. For example, in determining the depreciation expense, the useful life of the asset needs to be estimated and this cannot be known with any degree of certainty. As another example, liability provisions are created for liabilities of uncertain timing and/or amount. As paragraph 11 of IAS 37 Provisions , Contingent Liabilities, and Contingent Assets states, ‘provisions can be distinguished from other liabilities such as trade payables and accruals because t here is uncertainty about the timing of the amount of the future expenditure required in settlement ’. Paragraph 36 of IAS 37 further states that the ‘amount recognised as a provision shall be the best estimate of the expenditure required to settle the pres ent obligation at the end of the reporting period ’. The term ‘reliably ’ means the item can be objectively determined, and the reason behind estimation (if any) can be justified. Therefore, for a transaction or event to be recognised reporting entities hav e to satisfy the reliable measurement criteria even though they may not be able to be measure the transaction or event with certainty. A measurement is deemed to be reliable if it is complete, neutral and free from error. 2.18 Relevance is a fundamental qualitative characteristic of financial reporting. Under the IASB Conceptual Framework , information is regarded as relevant if it is considered capable of making a difference to a decision being made by users of the financial statements. Specifically, para graph QC 6 states: 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. There are two main aspects to relevance. For information to be relevant it should have both predictive value and confirmatory value (or feedback value), the latter referring to information ’s utility in confirming or correcting ear lier expectations. The other primary qualitative characteristic (other than relevance) is ‘faithful representation ’. According to the IASB Conceptual Framework , to be useful, financial information must not only represent relevant phenomena, but it must als o faithfully represent the phenomena that it purports to represent. According to paragraph QC 12 of the IASB Conceptual Framework : To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and fr ee from error. Of course, perfection is seldom, if ever, achievable. The Board ’s objective is to maximise those qualities to the extent possible. Ideally, financial information should be both relevant and representationally faithful. However, it is possibl e for information to be representationally faithful, but not very relevant, or the other way around. Such information would, in this case, not be deemed to be useful. As Paragraph QC 17 of the IASB Conceptual Framework states: Information must be both rele vant 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. There is often a trade -off between relevance an d representational faithfulness. For example, the earlier we can obtain the financial performance results of an entity, the more relevant the information will be in assessing that entity ’s performance. However, to increase the representational faithfulness of the data we might prefer to use financial information that has been the subject of an independent audit (therefore, for example, reducing the likelihood of error). The resultant increase in representational faithfulness, or reliability, will mean that Solutions Manual t/a Financial Accounting and Reporting by Deegan and Ward Copyright © 201 3 McGraw -Hill Australia Pty Ltd 2–10 we will not receive the information for perhaps 10 weeks after the financial year end, at which point the information will not be quite as relevant because of its ‘age’. Therefore, there can, in practice, be a matter of balancing one against the other. How ever if the data or information severely lacks one of the characteristics of relevance or faithful representation, then that information should not be provided to financial statement readers. 2.19 Pages 88 to 92 provide some criticisms of conceptual framew ork projects , such as the IASB Conceptual Framework . What must be remembered is that different parties will have different views about the need, or otherwise, for conceptual framework projects . Criticisms would include: • The definitions of the elements of a ccounting —with the focus on such attributes as ‘control ’—tend to exclude the consideration of social costs and benefits generated by a reporting entity (arguably, of course, these are very difficult to measure). • 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 equity investors, lenders and other creditors in making decisions about providing resources to the entity ’. Anybody who disagrees with the objective —upon which the Conceptual Framework is based —will then have problems accepting the balance of the Framework. If we were to believe that general purpose financial reports should also focus on providing info rmation about an entity ’s ability to support various segments of the community or perhaps to support sustainability related initiatives then we would believe the focus of the Framework is too narrow. • Linked to the above point, the determination of whether an entity is a reporting entity (and therefore required to produce general purpose financial statements) should primarily be dependent upon the existence of users who are dependent on general purpose financial statements for information to be used in makin g and evaluating economic decisions. By operating in the community, the company has a duty to provide information to people influenced by the organisation ’s activities, regardless of whether the interested parties are making resource allocation decisions. • Conceptual frameworks simply reflect a codification of existing practice which tends to describe existing, rather than ideal, practice. • Conceptual frameworks are used as a means of legitimising the ongoing existence of the accounting profession (that is, t hey prescribe characteristics such as objectivity). • The IASB Conceptual Framework was very slow to develop . • Specific to the IASB Framework , we have now replaced ‘revenue’ with ‘income’ as an element of financial statements. Income is to be broken down int o ‘gains ’ and ‘revenue ’. It is anticipated that it will not always be clear whether something should be classified as a ‘gain’ or ‘income ’ and hence it is questionable whether such a dichotomy is of value. 2.20 Materiality is closely tied to the qualitativ e characteristic of relevance. The IASB Conceptual Framework states that: Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. In other wo rds, materiality is an entity -specific aspect of relevance based on the nature or Solutions Manual t/a Financial Accounting and Reporting by Deegan and Ward Copyright © 201 3 McGraw -Hill Australia Pty Ltd 2–11 magnitude, or both, of the items to which the information relates in the context of an individual entity ’s financial report. Consequently, the Board cannot specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation. Assessing materiality is very much a matter of judgment. Generally speaking, if an item of information is not deemed material (which is, of course, a matter of professional judgment), the mode of disclosure or even whether or not it is disclosed at all should not affect the decisions of financial statement readers. Materiality, by definition, is therefore very economic in nature. Determining whether an item is material is not always a straightforward exercise and it is likely that different financial statement preparers will make different materiality assessments on various items. In deciding whether an item or an aggregate of items is material, the nat ure and amount of the items usually need to be evaluated together. It might be necessary to treat as material an item or an aggregate of items that would not be judged to be material on the basis of the amount involved, because of their nature. An example might be where a change in accounting method has taken place that is expected to affect materially the results of subsequent financial years, even though the effect in the current financial year is negligible. Paragraph 7 of IAS 1 Presentation of Financia l Statements states: Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor. Assessing whether an omission or misstatement could influence economic decisions of users, and so b e material, requires consideration of the characteristics of those users. Many accountancy firms provide guidance on materiality that relates to certain thresholds to their staff, for example a certain percentage of turnover, total assets or net income. Also the nature of the item is very important. For example, regardless of its size transactions with directors are deemed to be material due to their powerful position within the company and the agency potential that exists. Challenging questions 2.21 It is generally assumed that financial statements are regarded as being true and fair if they have been properly prepared in accordance with accounting standards. The true and fair requirement is fundamental to accounting in the UK and in the EU for m any years. Note: The requirement that company and consolidated accounts give a true and fair view is recognised in Article 2 (3) of the 4th Company Law Directive and Article 16 (3) of the 7th Company Law Directive issued by the European Commission. Althou gh these two Articles do not apply for accounts required to give a fair presentation in accordance with endorsed IFRS under the IAS Regulation, the true and fair principle underlying them is expressly Solutions Manual t/a Financial Accounting and Reporting by Deegan and Ward Copyright © 201 3 McGraw -Hill Australia Pty Ltd 2–12 recognised in Article 3(2) of the IAS Regulation – no IFRS standard can be endorsed in the EU if it would conflict with the principle set out in those Articles. However, s393 of the Companies Act 2006 enables directors to elect not to comply with an accounting standard if non -compliance is deemed necessary to create true and fair accounts. This is referred to as the ‘true and fair override’. Indeed the legislation requires that companies do not approve financial statements unless satisfied that they give a true and fair view. The perspective taken is that in some isolated cases certain accounting standards might not be appropriate for a particular entity and application of the standards might actually make the financial statements misleading. Numerous writers argued that as the true and fair view requirement is not clearly defined, directors could invoke the ‘true and fair override’ to justify not complying with particular accounting standards. Livne and McNichols (2009) conducted an empirical investigation into the use of the true and fair override by 1,141 UK companies over the period 1998 to 2002 (their analysis was restricted to 307 due to lack of a control sample). The authors ranked the types of override according to cost, wherein they classed overrides that have the greatest authoritative standing as b eing the most costly. For example, not complying with UK GAAP would have the highest cost as this is likely to cause conflict with auditors, potential intervention by regulatory bodies, and litigation as well as criticism by various market participants. T he benefits may include being able to satisfy debt covenants. The authors suggest that an override is only likely to occur when the benefit outweighs the cost. A lesser cost is an override of UK law to comply with UK GAAP. The authors found that only 19% of the overrides were non -compliance with UK GAAP, the majority being non - compliance with UK law in favour of UK GAAP. The authors found that firms with weaker performance and lower interest coverage ratios are more likely to invoke the more costly overri de. This conflicts with the argument that the override results in financial statement that portray more true and fair view as successful companies would be equally as likely to invoke the override. This argument did not hold when the weaker override sampl e was examined. The most common overrides noted in the sample included not depreciating investment properties, goodwill measurement and amortisation and not showing grants amortised in deferred income. 2.22 According to the Conceptual Framework (para graph QC11) , an item is material if: omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. In other words, materiality is an entity -specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity ’s financial report. In addition, paragraph 7 of IAS 1 Presentation of Financial Statements states: Omissions or misstatements of item s are material if they could, individually or collectively, influence the economic decisions that users make on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circ umstances. The size or nature of the item, or a combination of both, could be the determining factor. Assessing whether an omission or misstatement could influence economic decisions of