PAPER F7 FINANCIAL REPORTING (INTERNATIONAL)

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2 S T U D Y PAPER F7 FINANCIAL REPORTING (INTERNATIONAL) T E X T In this new syllabus first edition approved by ACCA We discuss the best strategies for studying for ACCA exams We highlight the most important elements in the syllabus and the key skills you will need We signpost how each chapter links to the syllabus and the study guide We provide lots of exam focus points demonstrating what the examiner will want you to do We emphasise key points in regular fast forward summaries We test your knowledge of what you've studied in quick quizzes We examine your understanding in our exam question bank We reference all the important topics in our full index BPP's i-learn and i-pass products also support this paper. FOR EXAMS IN DECEMBER 2009 AND JUNE 2010

3 First edition 2007 Third edition June 2009 ISBN (Previous ISBN ) British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Published by BPP Learning Media Ltd BPP House, Aldine Place London W12 8AA Printed in the United Kingdom All our rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of BPP Learning Media Ltd. We are grateful to the Association of Chartered Certified Accountants for permission to reproduce past examination questions. The suggested solutions in the exam answer bank have been prepared by BPP Learning Media Ltd, unless otherwise stated. Your learning materials, published by BPP Learning Media Ltd, are printed on paper sourced from sustainable, managed forests. BPP Learning Media Ltd 2009 ii

4 Contents Introduction How the BPP ACCA-approved Study Text can help you pass...(v) Studying F7...(vii) The exam paper...(viii) 1 The conceptual framework The regulatory framework Presentation of published financial statements Non-current assets Intangible assets Impairment of assets Reporting financial performance Introduction to groups The consolidated statement of financial position The consolidated income statement Accounting for associates Inventories and construction contracts Provisions, contingent liabilities and contingent assets Financial assets and liabilities The legal versus the commercial view of accounting Leasing Accounting for taxation Earnings per share Analysing and interpreting financial statements Limitations of financial statements and interpretation techniques Statements of cash flows Alternative models and practices Specialised, not-for-profit and public sector entities Exam question bank Exam answer bank Index Review form and free prize draw Page iii

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6 How the BPP ACCA-approved Study Text can help you pass your exams AND help you with your Practical Experience Requirement! NEW FEATURE the PER alert! Before you can qualify as an ACCA member, you do not only have to pass all your exams but also fulfil a three year practical experience requirement (PER). To help you to recognise areas of the syllabus that you might be able to apply in the workplace to achieve different performance objectives, we have introduced the PER alert feature. You will find this feature throughout the Study Text to remind you that what you are learning to pass your ACCA exams is equally useful to the fulfilment of the PER requirement. Tackling studying Studying can be a daunting prospect, particularly when you have lots of other commitments. The different features of the text, the purposes of which are explained fully on the Chapter features page, will help you whilst studying and improve your chances of exam success. Developing exam awareness Our Texts are completely focused on helping you pass your exam. Our advice on Studying F7 outlines the content of the paper, the necessary skills the examiner expects you to demonstrate and any brought forward knowledge you are expected to have. Exam focus points are included within the chapters to highlight when and how specific topics were examined, or how they might be examined in the future. Using the Syllabus and Study Guide You can find the syllabus, Study Guide and other useful resources for F7 on the ACCA web site: The Study Text covers all aspects of the syllabus to ensure you are as fully prepared for the exam as possible. Testing what you can do Testing yourself helps you develop the skills you need to pass the exam and also confirms that you can recall what you have learnt. We include Questions lots of them - both within chapters and in the Exam Question Bank, as well as Quick Quizzes at the end of each chapter to test your knowledge of the chapter content. Introduction v

7 Chapter features Each chapter contains a number of helpful features to guide you through each topic. Topic list Topic list Syllabus reference Tells you what you will be studying in this chapter and the relevant section numbers, together the ACCA syllabus references. Introduction Study Guide Exam Guide Knowledge brought forward from earlier studies FAST FORWARD Examples Key terms Exam focus points Formula to learn Question Case Study Chapter Roundup Quick Quiz Exam Question Bank Puts the chapter content in the context of the syllabus as a whole. Links the chapter content with ACCA guidance. Highlights how examinable the chapter content is likely to be and the ways in which it could be examined. What you are assumed to know from previous studies/exams. Summarises the content of main chapter headings, allowing you to preview and review each section easily. Demonstrate how to apply key knowledge and techniques. Definitions of important concepts that can often earn you easy marks in exams. Tell you when and how specific topics were examined, or how they may be examined in the future. Formulae that are not given in the exam but which have to be learnt. This is a new feature that gives you a useful indication of syllabus areas that closely relate to performance objectives in your Practical Experience Requirement (PER). Give you essential practice of techniques covered in the chapter. Provide real world examples of theories and techniques. A full list of the Fast Forwards included in the chapter, providing an easy source of review. A quick test of your knowledge of the main topics in the chapter. Found at the back of the Study Text with more comprehensive chapter questions. Cross referenced for easy navigation. vi Introduction

8 Studying F7 F7 is a demanding paper covering all the fundamentals of financial reporting. It has five main sections: 1. The conceptual framework of accounting 2. The regulatory framework 3. Preparation of financial statements which conform with IFRS 4. Preparation of consolidated financial statements 5. Analysis and interpretation of financial statements All of these areas will be tested to some degree at each sitting. Sections 3 and 4 are the main areas of application and you must expect to have to produce consolidated and single company financial statements in your exam. Some of this material you will have covered at lower level papers. You should already be familiar with accounting for inventories and non-current assets and preparing simple income statements, statements of financial position and statements of cash flows. You should know the basic ratios. F7 takes your financial reporting knowledge and skills up to the next level. New topics are consolidated financial statements, construction contracts, financial instruments and leases. There is also coverage of the substance of transactions and the limitations of financial statements and ratios. The examiner wants you to think about these issues. If you had exemptions from lower level papers or feel that your knowledge of lower level financial reporting is not good enough, you may want to get a copy of the study text for F3 Financial Accounting and read through it, or at least have it to refer to. You have a lot of new material to learn for F7 and basic financial accounting will be assumed knowledge. The way to pass F7 is by practising lots of exam-level questions, which you will do when you get onto revision. Only by practising questions do you get a feel for what you will have to do in the exam. Also, topics which you find hard to understand in the text will be much easier to grasp when you have encountered them in a few questions. So don t get bogged down in any area of the text. Just keep going and a lot of things you find difficult will make more sense when you see how they appear in an exam question. Introduction vii

9 The exam paper The exam is a three hour paper with five compulsory questions. Format of the paper Marks Question 1 25 Question 2 25 Question 3 25 Question 4 15 Question Question 1 will be on consolidated financial statements. Question 2 will be on single company financial statements. Question 3 is likely to be on cash flow statements or interpretation of accounts Questions 4 and 5 will be on other areas of the syllabus A certain number of IFRSs/IASs will be tested in questions 1 and 2. Others will appear in questions 4 and 5. The examiner has in the past used questions 4 and 5 to test construction contracts, deferred tax, provisions and issues relating to non-current assets. viii Introduction

10 Analysis of past papers The table below provides details of when each element of the syllabus has been examined and the question number and section in which each element appeared. Further details can be found in the Exam Focus Points in the relevant chapters. Covered in Text chapter Pilot Paper Dec 2007 June 2008 Dec 2008 A CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING 1 The need or a conceptual framework 1 Understandability, relevance, reliability and comparability Framework qualitative characteristics Q4 Q4 Q4 Q4 Accounting policies, changes I accounting estimates and errors Q4 Q5 Q2 1 Recognition and measurement Q4 15 The legal versus the commercial view of accounting Q2 22 Alternative models and practices (accounting for inflation) Q4 1 The concept of 'faithful representation' ('true and fair view') Q4 A REGULATORY FRAMEWORK FOR FINANCIAL REPORTING 2 Reasons for the existence of a regulatory framework 2 The standard setting process 23 Specialised, not-for-profit and public sector entities FINANCIAL STATEMENTS 21 Statements of cash flows Q3 4 Tangible non-current assets Property, plant and equipment Investment properties Government grants Borrowing costs Q2 Q2 Q2 Q2 Q2, Q5 5 Intangible assets Q5 Q2 12 Inventories and construction contracts Q2, Q5 Q4 14 Financial assets and financial liabilities Fair value through profit or loss Amortised cost Convertible debt Q2 Q1 Q2 16 Leases Q2, Q4 Q4 13 Provisions, contingent liabilities and contingent assets Q2, Q4 Q2 Q5 Q2 6 Impairment of assets Group accounting Other Q1 Q1 17 Taxation Current tax Deferred tax Q2 Q2 Q2 Q2 Q2 Q2 Q2 Q2 Introduction ix

11 Covered in Text chapter Pilot Paper Dec 2007 June 2008 Dec 2008 FINANCIAL STATEMENTS 3 Regulatory requirements relating to the preparation of financial statements Income statement Statement of comprehensive income Statement of financial position Statement of changes in equity Q2 Q2 Q2 Q2 Q2 7 Reporting financial performance Discontinued operations Non-current assets held for sale Earnings per share Q2(c) BUSINESS COMBINATIONS Q2 Q2(c) Q2 Q2 Q2(c) Q2 8 The concept and principles of a group Q1 Q1(c) 8 The concept of consolidated financial statements Q Preparation of consolidated financial statements: Consolidated income statement Consolidated statement of comprehensive income Consolidated statement of financial position Associates Q1 Q1 Q1 Q1 Q1 Q1 Q1 ANALYSING AND INTERPRETING FINANCIAL STATEMENTS 20 Limitations of financial statements 19 Calculation and interpretation of accounting ratios and trends to address users' and stakeholders' needs Q3 Q3 Q3 Q3 20 Limitations of interpretation techniques Q3(c) 23 Specialised, not-for-profit and public sector entities Q3(c) x Introduction

12 The conceptual framework Topic list Syllabus reference 1 Conceptual framework and GAAP A1 2 The IASB's Framework A1 3 The objective of financial statements A2 4 Underlying assumptions A2 5 Qualitative characteristics of financial statements A2 6 The elements of financial statements A3 7 Recognition of the elements of financial statements A3 8 Measurement of the elements of financial statements A3 9 Fair presentation and compliance with IFRS A6 Introduction The IASB's document Framework for the preparation and presentation of financial statements represents the conceptual framework on which all IASs are based. A conceptual framework for financial reporting can be defined as an attempt to codify existing generally accepted accounting practice (GAAP) in order to reappraise current accounting standards and to produce new standards. 1

13 Study guide A A CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING 1 The need for a conceptual framework Intellectual level describe what is meant by a conceptual framework of accounting 2 discuss whether a conceptual framework is necessary and what an alternative system might be 2 Understandability, relevance, reliability and comparability discuss what is meant by understandability in relation to the provision of financial information discuss what is meant by relevance and reliability and describe the qualities that enhance these characteristics (c) discuss the importance of comparability to users of financial statements 2 3 Recognition and measurement define what is meant by 'recognition' in financial statements and discuss the recognition criteria apply the recognition criteria to: 2 (c) (d) (i) (ii) assets and liabilities income and expenses discuss revenue recognition issues and indicate when income and expense recognition should occur. demonstrate the role of the principle of substance over form in relation to recognising sales revenue. (e) explain the following measures and compute amounts using: 2 (i) (ii) (iii) (iv) historical cost fair value/current cost net realisable value present value of future cash flows. 6 The concept of 'faithful representation' ('true and fair view') (c) describe what is meant by financial statements achieving a faithful representation. discuss whether faithful representation constitutes more than compliance with accounting standards. indicate the circumstances and required disclosures where a 'true and fair' override may apply : The conceptual framework F7 Financial reporting

14 1 Conceptual framework and GAAP FAST FORWARD There are advantages and disadvantages to having a conceptual framework. 1.1 The search for a conceptual framework A conceptual framework, in the field we are concerned with, is a statement of generally accepted theoretical principles which form the frame of reference for financial reporting. These theoretical principles provide the basis for the development of new accounting standards and the evaluation of those already in existence. The financial reporting process is concerned with providing information that is useful in the business and economic decision-making process. Therefore a conceptual framework will form the theoretical basis for determining which events should be accounted for, how they should be measured and how they should be communicated to the user. Although it is theoretical in nature, a conceptual framework for financial reporting has highly practical final aims. The danger of not having a conceptual framework is demonstrated in the way some countries' standards have developed over recent years; standards tend to be produced in a haphazard and fire-fighting approach. Where an agreed framework exists, the standard-setting body act as an architect or designer, rather than a fire-fighter, building accounting rules on the foundation of sound, agreed basic principles. The lack of a conceptual framework also means that fundamental principles are tackled more than once in different standards, thereby producing contradictions and inconsistencies in basic concepts, such as those of prudence and matching. This leads to ambiguity and it affects the true and fair concept of financial reporting. Another problem with the lack of a conceptual framework has become apparent in the USA. The large number of highly detailed standards produced by the Financial Accounting Standards Board (FASB) has created a financial reporting environment governed by specific rules rather than general principles. This would be avoided if a cohesive set of principles were in place. A conceptual framework can also bolster standard setters against political pressure from various 'lobby groups' and interested parties. Such pressure would only prevail if it was acceptable under the conceptual framework. 1.2 Advantages and disadvantages of a conceptual framework Advantages (c) The situation is avoided whereby standards are developed on a patchwork basis, where a particular accounting problem is recognised as having emerged, and resources were then channelled into standardising accounting practice in that area, without regard to whether that particular issue was necessarily the most important issue remaining at that time without standardisation. As stated above, the development of certain standards (particularly national standards) have been subject to considerable political interference from interested parties. Where there is a conflict of interest between user groups on which policies to choose, policies deriving from a conceptual framework will be less open to criticism that the standard-setter buckled to external pressure. Some standards may concentrate on the income statement whereas some may concentrate on the valuation of net assets (statement of financial position). Disadvantages (c) Financial statements are intended for a variety of users, and it is not certain that a single conceptual framework can be devised which will suit all users. Given the diversity of user requirements, there may be a need for a variety of accounting standards, each produced for a different purpose (and with different concepts as a basis). It is not clear that a conceptual framework makes the task of preparing and then implementing standards any easier than without a framework. F7 Financial reporting 1: The conceptual framework 3

15 Before we look at the IASB's attempt to produce a conceptual framework, we need to consider another term of importance to this debate: generally accepted accounting practice; or GAAP. 1.3 Generally Accepted Accounting Practice (GAAP) GAAP signifies all the rules, from whatever source, which govern accounting. In individual countries this is seen primarily as a combination of: National company law National accounting standards Local stock exchange requirements Although those sources are the basis for the GAAP of individual countries, the concept also includes the effects of non-mandatory sources such as: International accounting standards Statutory requirements in other countries In many countries, like the UK, GAAP does not have any statutory or regulatory authority or definition, unlike other countries, such as the USA. The term is mentioned rarely in legislation, and only then in fairly limited terms. There are different views of GAAP in different countries. The UK position can be explained in the following extracts from UK GAAP (Davies, Paterson & Wilson, Ernst & Young, 5 th edition). 'Our view is that GAAP is a dynamic concept which requires constant review, adaptation and reaction to changing circumstances. We believe that use of the term 'principle' gives GAAP an unjustified and inappropriate degree of permanence. GAAP changes in response to changing business and economic needs and developments. As circumstances alter, accounting practices are modified or developed accordingly.. We believe that GAAP goes far beyond mere rules and principles, and encompasses contemporary permissible accounting practice. It is often argued that the term 'generally accepted' implies that there must exist a high degree of practical application of a particular accounting practice. However, this interpretation raises certain practical difficulties. For example, what about new areas of accounting which have not, as yet, been generally applied? What about different accounting treatments for similar items are they all generally accepted? 'It is our view that 'generally accepted' does not mean 'generally adopted or used'. We believe that, in the UK context, GAAP refers to accounting practices which are regarded as permissible by the accounting profession. The extent to which a particular practice has been adopted is, in our opinion, not the overriding consideration. Any accounting practice which is legitimate in the circumstances under which it has been applied should be regarded as GAAP. The decision as to whether or not a particular practice is permissible or legitimate would depend on one or more of the following factors: Is the practice addressed either in the accounting standards, statute or other official pronouncements? If the practice is not addressed in UK accounting standards, is it dealt with in International Accounting Standards, or the standards of other countries such as the US? Is the practice consistent with the needs of users and the objectives of financial reporting? Does the practice have authoritative support in the accounting literature? Is the practice being applied by other companies in similar situations? Is the practice consistent with the fundamental concept of 'true and fair'?' This view is not held in all countries, however. In the USA particularly, the equivalent of a 'true and fair view' is 'fair presentation in accordance with GAAP'. Generally accepted accounting principles are defined as those principles which have 'substantial authoritative support'. Therefore accounts prepared in accordance with accounting principles for which there is not substantial authoritative support are presumed to be misleading or inaccurate. 4 1: The conceptual framework F7 Financial reporting

16 The effect here is that 'new' or 'different' accounting principles are not acceptable unless they have been adopted by the mainstream accounting profession, usually the standard-setting bodies and/or professional accountancy bodies. This is much more rigid than the UK view expressed above. A conceptual framework for financial reporting can be defined as an attempt to codify existing GAAP in order to reappraise current accounting standards and to produce new standards. 2 The IASB's Framework FAST FORWARD The Framework provides the conceptual framework for the development of IFRSs/IASs. In July 1989 the IASB (then IASC) produced a document, Framework for the preparation and presentation of financial statements ('Framework'). The Framework is, in effect, the conceptual framework upon which all IASs are based and hence which determines how financial statements are prepared and the information they contain. The Framework consists of several sections or chapters, following on after a preface and introduction. These chapters are as follows. The objective of financial statements Underlying assumptions Qualitative characteristics of financial statements The elements of financial statements Recognition of the elements of financial statements Measurement of the elements of financial statements Concepts of capital and capital maintenance We will look briefly at the preface and introduction to the Framework as these will place the document in context with the rest of what you have studied for this paper and in particular the context of the Framework in the IASB's approach to developing IASs. As you read through this chapter think about the impact the Framework has had on IASs, particularly the definitions. 2.1 Preface The preface to the Framework points out the fundamental reason why financial statements are produced worldwide, ie to satisfy the requirements of external users, but that practice varies due to the individual pressures in each country. These pressures may be social, political, economic or legal, but they result in variations in practice from country to country, including the form of statements, the definition of their component parts (assets, liabilities etc), the criteria for recognition of items and both the scope and disclosure of financial statements. It is these differences which the IASB wishes to narrow by harmonising all aspects of financial statements, including the regulations governing their accounting standards and their preparation and presentation. The preface emphasises the way financial statements are used to make economic decisions and thus financial statements should be prepared to this end. The types of economic decisions for which financial statements are likely to be used include the following. Decisions to buy, hold or sell equity investments Assessment of management stewardship and accountability Assessment of the entity's ability to pay employees Assessment of the security of amounts lent to the entity Determination of taxation policies Determination of distributable profits and dividends Inclusion in national income statistics Regulations of the activities of entities F7 Financial reporting 1: The conceptual framework 5

17 Any additional requirements imposed by national governments for their own purposes should not affect financial statements produced for the benefit of other users. The Framework recognises that financial statements can be prepared using a variety of models. Although the most common is based on historical cost and a nominal unit of currency (ie pound sterling, US dollar etc), the Framework can be applied to financial statements prepared under a range of models. 2.2 Introduction The introduction to the Framework lays out the purpose, status and scope of the document. It then looks at different users of financial statements and their information needs Purpose and status The introduction gives a list of the purposes of the Framework. (c) (d) (e) (f) (g) Assist the Board of the IASB in the development of future IASs and in its review of existing IASs. Assist the Board of the IASB in promoting harmonisation of regulations, accounting standards and procedures relating to the presentation of financial statements by providing a basis for reducing the number of alternative accounting treatments permitted by IASs. Assist national standard-setting bodies in developing national standards. Assist preparers of financial statements in applying IASs and in dealing with topics that have yet to form the subject of an IAS. Assist auditors in forming an opinion as to whether financial statements conform with IASs. Assist users of financial statements in interpreting the information contained in financial statements prepared in conformity with IASs. Provide those who are interested in the work of IASB with information about its approach to the formulation of IASs (now IFRSs). The Framework is not an IAS and so does not overrule any individual IAS. In the (rare) cases of conflict between an IAS and the Framework, the IAS will prevail. These cases will diminish over time as the Framework will be used as a guide in the production of future IASs. The Framework itself will be revised occasionally depending on the experience of the IASB in using it Scope The Framework deals with: (c) (d) The objective of financial statements The qualitative characteristics that determine the usefulness of information in financial statements The definition, recognition and measurement of the elements from which financial statements are constructed Concepts of capital and capital maintenance The Framework is concerned with 'general purpose' financial statements (ie a normal set of annual statements), but it can be applied to other types of accounts. A complete set of financial statements includes: (c) (d) A statement of financial position A statement of comprehensive income A statement of changes in financial position (eg a statement of cash flows) Notes, other statements and explanatory material Supplementary information may be included, but some items are not included in the financial statements themselves, namely commentaries and reports by the directors, the chairman, management etc. All types of financial reporting entities are included (commercial, industrial, business; public or private sector). 6 1: The conceptual framework F7 Financial reporting

18 Key term A reporting entity is an entity for which there are users who rely on the financial statements as their major source of financial information about the entity. (Framework) Users and their information needs We have already looked at the users of accounting information in Chapter 1. They consist of investors, employees, lenders, suppliers and other trade creditors, customers, government and their agencies and the public. You should be able to remember enough to do the following exercise. Question Users of financial information Consider the information needs of the users of financial information listed above. Answer Investors are the providers of risk capital (i) (ii) (iii) (iv) Information is required to help make a decision about buying or selling shares, taking up a rights issue and voting. Investors must have information about the level of dividend, past, present and future and any changes in share price. Investors will also need to know whether the management has been running the company efficiently. As well as the position indicated by the statement of comprehensive income, statement of financial position and earnings per share (EPS), investors will want to know about the liquidity position of the company, the company's future prospects, and how the company's shares compare with those of its competitors. (c) (d) (e) (f) (g) Employees need information about the security of employment and future prospects for jobs in the company, and to help with collective pay bargaining. Lenders need information to help them decide whether to lend to a company. They will also need to check that the value of any security remains adequate, that the interest repayments are secure, that the cash is available for redemption at the appropriate time and that any financial restrictions (such as maximum debt/equity ratios) have not been breached. Suppliers need to know whether the company will be a good customer and pay its debts. Customers need to know whether the company will be able to continue producing and supplying goods. Government's interest in a company may be one of creditor or customer, as well as being specifically concerned with compliance with tax and company law, ability to pay tax and the general contribution of the company to the economy. The public at large would wish to have information for all the reasons mentioned above, but it could be suggested that it would be impossible to provide general purpose accounting information which was specifically designed for the needs of the public. Financial statements cannot meet all these users' needs, but financial statements which meet the needs of investors (providers of risk capital) will meet most of the needs of other users. The Framework emphasises that the preparation and presentation of financial statements is primarily the responsibility of an entity's management. Management also has an interest in the information appearing in financial statements. F7 Financial reporting 1: The conceptual framework 7

19 2.3 IAS 1 Presentation of financial statements Much of what IAS 1 states in relation to accounting policies and the formats of financial statements repeats the contents of the Framework document. IAS 1 is considered in detail in Chapter 3. 3 The objective of financial statements FAST FORWARD The Framework states that: 'The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions.' Such financial statements will meet the needs of most users. The information is, however, restricted. It is based on past events not expected future events. It does not necessarily contain non-financial information. The statements also show the results of management's stewardship. 3.1 Financial position, performance and changes in financial position It is important for users to assess the ability of an entity to produce cash and cash equivalents to pay employees, lenders etc. Financial position information is affected by the following and information about each one can aid the user. (c) Economic resources controlled: to predict the ability to generate cash Financial structure: to predict borrowing needs, the distribution of future profits/cash and likely success in raising new finance Liquidity and solvency: to predict whether financial commitments will be met as they fall due (liquidity relates to short-term commitments, solvency is longer-term) Key term Liquidity. The availability of sufficient funds to meet deposit withdrawals and other short-term financial commitments as they fall due. Solvency. The availability of cash over the longer term to meet financial commitments as they fall due. (Framework) In all these areas, the capacity to adapt to changes in the environment in which the entity operates is very important. Financial performance (statement of comprehensive income) information, particularly profitability, is used to assess potential changes in the economic resources the entity is likely to control in future. Information about performance variability is therefore important. Changes in financial position (ie statement of cash flows) information is used to assess the entity's investing, financing and operating activities. They show the entity's ability to produce cash and the needs which utilise those cash flows. All parts of the financial statements are interrelated, reflecting different aspects of the same transactions or events. Each statement provides different information; none can provide all the information required by users. 8 1: The conceptual framework F7 Financial reporting

20 4 Underlying assumptions FAST FORWARD Accruals and going concern are the two underlying assumptions in preparing financial statements. Key term 4.1 Accruals basis Accruals basis. The effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate. (Framework) Financial statements prepared under the accruals basis show users past transactions involving cash and also obligations to pay cash in the future and resources which represent cash to be received in the future. Key term 4.2 Going concern Going concern. The entity is normally viewed as a going concern, that is, as continuing in operation for the foreseeable future. It is assumed that the entity has neither the intention nor the necessity of liquidation or of curtailing materially the scale of its operations. (Framework) It is assumed that the entity has no intention to liquidate or curtail major operations. If it did, then the financial statements would be prepared on a different (disclosed) basis. 5 Qualitative characteristics of financial statements FAST FORWARD The Framework states that qualitative characteristics are the attributes that make the information provided in financial statements useful to users. The four principal qualitative characteristics are understandability, relevance, reliability and comparability. 5.1 Understandability Users must be able to understand financial statements. They are assumed to have some business, economic and accounting knowledge and to be able to apply themselves to study the information properly. Complex matters should not be left out of financial statements simply due to its difficulty if it is relevant information. 5.2 Relevance Key term The predictive and confirmatory roles of information are interrelated. Relevance. Information has the quality of relevance when it influences the economic decisions of users by helping them evaluate past, present or future events or confirming, or correcting, their past evaluations. (Framework) Information on financial position and performance is often used to predict future position and performance and other things of interest to the user, eg likely dividend, wage rises. The manner of showing information will enhance the ability to make predictions, eg by highlighting unusual items. F7 Financial reporting 1: The conceptual framework 9

21 5.2.1 Materiality Key term The relevance of information is affected by its nature and materiality. Materiality. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. (Framework) Information may be judged relevant simply because of its nature (eg remuneration of management). In other cases, both the nature and materiality of the information are important. Materiality is not a primary qualitative characteristic itself (like reliability or relevance), because it is merely a threshold or cut-off point. 5.3 Reliability Key term Exam focus point Information must also be reliable to be useful. The user must be able to depend on it being a faithful representation. Reliability. Information has the quality of reliability when it is free from material error and bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent. (Framework) Even if information is relevant, if it is very unreliable it may be misleading to recognise it, eg a disputed claim for damages in a legal action. The pilot paper has a question on qualitative characteristics of financial information Faithful representation Information must represent faithfully the transactions it purports to represent in order to be reliable. There is a risk that this may not be the case, not due to bias, but due to inherent difficulties in identifying the transactions or finding an appropriate method of measurement or presentation. Where measurement of the financial effects of an item is so uncertain, entities should not recognise such an item, eg internally generated goodwill Substance over form Key term Faithful representation of a transaction is only possible if it is accounted for according to its substance and economic reality, not with its legal form. Substance over form. The principle that transactions and other events are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. (Framework) For instance, one party may sell an asset to another party and the sales documentation may record that legal ownership has been transferred. However, if agreements exist whereby the party selling the asset continues to enjoy the future economic benefits arising from the asset, then in substance no sale has taken place. This issue is covered in more detail in Chapter Neutrality Information must be free from bias to be reliable. Neutrality is lost if the financial statements are prepared so as to influence the user to make a judgement or decision in order to achieve a predetermined outcome Prudence Uncertainties exist in the preparation of financial information, eg the collectability of doubtful receivables. These uncertainties are recognised through disclosure and through the application of prudence. Prudence 10 1: The conceptual framework F7 Financial reporting

22 does not, however, allow the creation of hidden reserves or excessive provisions, understatement of assets or income or overstatement of liabilities or expenses Completeness Financial information must be complete, within the restrictions of materiality and cost, to be reliable. Omission may cause information to be misleading. 5.4 Comparability Users must be able to compare an entity's financial statements: Through time to identify trends With other entities' statements, to evaluate their relative financial position, performance and changes in financial position The consistency of treatment is therefore important across like items over time, within the entity and across all entities. The disclosure of accounting policies is particularly important here. Users must be able to distinguish between different accounting policies in order to be able to make a valid comparison of similar items in the accounts of different entities. Comparability is not the same as uniformity. Entities should change accounting policies if they become inappropriate. Corresponding information for preceding periods should be shown to enable comparison over time. 5.5 Constraints on relevant and reliable information Timeliness Information may become irrelevant if there is a delay in reporting it. There is a balance between timeliness and the provision of reliable information. Information may be reported on a timely basis when not all aspects of the transaction are known, thus compromising reliability. If every detail of a transaction is known, it may be too late to publish the information because it has become irrelevant. The overriding consideration is how best to satisfy the economic decision-making needs of the users Balance between benefits and cost This is a pervasive constraint, not a qualitative characteristic. When information is provided, its benefits must exceed the costs of obtaining and presenting it. This is a subjective area and there are other difficulties: others than the intended users may gain a benefit; also the cost may be paid by someone other than the users. It is therefore difficult to apply a cost-benefit analysis, but preparers and users should be aware of the constraint Balance between qualitative characteristics A trade off between qualitative characteristics is often necessary, the aim being to achieve an appropriate balance to meet the objective of financial statements. It is a matter for professional judgement as to the relative importance of these characteristics in each case. 5.6 True and fair view/fair presentation The Framework does not attempt to define these concepts directly. It does state, however, that the application of the principal 'qualitative' characteristics and of appropriate accounting standards will usually result in financial statements which show a true and fair view, or present fairly. F7 Financial reporting 1: The conceptual framework 11

23 6 The elements of financial statements FAST FORWARD Transactions and other events are grouped together in broad classes and in this way their financial effects are shown in the financial statements. These broad classes are the elements of financial statements. The Framework lays out these elements as follows. Elements of financial statements Measurement of financial position in the balance sheet Measurement of performance in the income statement Assets Liabilities Equality Income Expenses A process of sub-classification then takes place for presentation in the financial statements, eg assets are classified by their nature or function in the business to show information in the best way for users to take economic decisions. 6.1 Financial position Key terms We need to define the three terms listed under this heading above. Asset. A resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity. Liability. A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Equity. The residual interest in the assets of the entity after deducting all its liabilities. (Framework) These definitions are important, but they do not cover the criteria for recognition of any of these items, which are discussed in the next section of this chapter. This means that the definitions may include items which would not actually be recognised in the statement of financial position because they fail to satisfy recognition criteria particularly, as we will see below, the probable flow of any economic benefit to or from the business. Whether an item satisfies any of the definitions above will depend on the substance and economic reality of the transaction, not merely its legal form. For example, consider finance leases (see Chapter 16). 6.2 Assets Key term We can look in more detail at the components of the definitions given above. Future economic benefit. The potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity. The potential may be a productive one that is part of the operating activities of the entity. It may also take the form of convertibility into cash or cash equivalents or a capability to reduce cash outflows, such as when an alternative manufacturing process lowers the cost of production. (Framework) 12 1: The conceptual framework F7 Financial reporting

24 Assets are usually employed to produce goods or services for customers; customers will then pay for these. Cash itself renders a service to the entity due to its command over other resources. The existence of an asset, particularly in terms of control, is not reliant on: physical form (hence patents and copyrights); nor legal rights (hence leases). Transactions or events in the past give rise to assets; those expected to occur in the future do not in themselves give rise to assets. For example, an intention to purchase a non-current asset does not, in itself, meet the definition of an asset. 6.3 Liabilities Key term Again we can look more closely at some aspects of the definition. An essential characteristic of a liability is that the entity has a present obligation. Obligation. A duty or responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise, however, from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner. (Framework) It is important to distinguish between a present obligation and a future commitment. A management decision to purchase assets in the future does not, in itself, give rise to a present obligation. Settlement of a present obligation will involve the entity giving up resources embodying economic benefits in order to satisfy the claim of the other party. This may be done in various ways, not just by payment of cash. Liabilities must arise from past transactions or events. In the case of, say, recognition of future rebates to customers based on annual purchases, the sale of goods in the past is the transaction that gives rise to the liability Provisions Key term Is a provision a liability? Provision. A present obligation which satisfies the rest of the definition of a liability, even if the amount of the obligation has to be estimated. (Framework) Question Definite variables Consider the following situations. In each case, do we have an asset or liability within the definitions given by the Framework? Give reasons for your answer. (c) Pat Co has purchased a patent for $20,000. The patent gives the company sole use of a particular manufacturing process which will save $3,000 a year for the next five years. Baldwin Co paid Don Brennan $10,000 to set up a car repair shop, on condition that priority treatment is given to cars from the company's fleet. Deals on Wheels Co provides a warranty with every car sold. Answer This is an asset, albeit an intangible one. There is a past event, control and future economic benefit (through cost savings). This cannot be classified as an asset. Baldwin Co has no control over the car repair shop and it is difficult to argue that there are 'future economic benefits'. F7 Financial reporting 1: The conceptual framework 13