CIMA F1 Financial Operations Student Notes
Contents CIMA F1...1 Topic 6 The Regulatory Environment...2 International Financial Reporting Standards (IFRSs)...5 Topic 7: The Conceptual Framework...7 Topic 8: External Audit... 16 Topic 9: Code of ethics... 25 Topic 10: Corporate Governance... 33 CIMA F1 1
Topic 6 The Regulatory Environment A1a: Explain the need for the regulation of the financial reporting information of incorporated entities and the key elements of an ethical regulatory environment for such information A1b: Explain the roles and structures of the key bodies involved in the regulation of financial reporting information. Need for regulation Because of the importance of published accounts giving a fair presentation to the users of these accounts, they need to be regulated. Without such regulation consistency of accounts preparation is undermined. Regulatory bodies The IFRS Foundation 22 Trustees IFRS Advisory Council International Accounting Standards Board IFRS Interpretations Committee Appoints members Advises Reports CIMA F1 2
IFRS Advisory Council The IFRS Advisory Council (formally called the SAC) provides a forum for organisations and individuals to participate in the standard-setting process. It is way the IASB consults with the outside world. The objectives of the IFRS Advisory Council Care: To give advice to the IASB on agenda decisions and priorities in its work; To inform the IASB of the views of organisations and individuals on the Council on major standard-setting projects; To give other advice to the Board or to the Trustees. CIMA F1 3
IFRS Interpretations Committee (IFRS IC) The IFRS Interpretations Committee (formally known as the International Financial Reporting Interpretations committee or IFRIC) was originally established in 2002. They provide guidance on specific practical issues in the interpretation of IFRS. Note that despite the name change. Interpretations issued by the IFRS Interpretations Committee are still known as IFRIC interpretations. In your exam, you may see the IFRS Interpretations Committee referred to as the IFRS IC. The responsibilities of the IFRS IC: 1. To review on a timely basis, newly identified financial reporting issues not specifically addressed in IFRSs 2. To clarify issues where unsatisfactory or conflicting interpretations have developed, or seem likely to develop in the absence of authoritative guidance, with a view to reaching a consensus on the appropriate treatment. Apply Your Knowledge 1 What is the role of the IFRS Interpretations committee? A. To develop and issue a set of globally accepted international financial reporting standards B. To clarify issues in the application of IFRS s where unsatisfactory or conflicting interpretations has developed C. To take account of the financial reporting needs of small and medium sized entities D. To provide a forum for the IASB to consult with the national accounting standard setters, academics and other interested parties Apply Your Knowledge 2 Which of the following is responsible for developing and issuing IFRSs (International Financial Reporting Standards)? A. IFRS Foundation B. IFRS Interpretations committee C. International Accounting Standards Board (IASB) D. IFRS Advisory Council CIMA F1 4
International Financial Reporting Standards (IFRSs) A1c: Explain the scope of IFRS and how they are developed. There are currently 41 IASs and 13 IFRSs in issue. The use and application of FRSs PLEASE NOTE THROUGHOUT THIS COURSE WE WILL USE THE ABBREVIATION IFRSs TO INCLUDE BOTH IFRSs AND IASs. The IFRSs have helped to improve and harmonise financial reporting around the world. The standards are used in the following ways: 1. As national requirements 2. As the basis for all or some national requirements 3. As an international benchmark for those counties which develop their own requirements 4. By regulatory authorities for domestic and foreign companies 5. By companies themselves In the UK the consolidated accounts of listed companies have had to be produced in accordance with IFRSs since January 2005. Standard-setting process The IASB prepares IFRSs in accordance with due process. Establishment of a consultative group to give advice on the issues arising on the project. The IASB will consult with this committee and IFRS advisory council throughout the process. On acceptance of a project a steering committee is set up (chaired by board members); On major projects, the IASB develops and publishes a Discussion Document for public comment; Following the receipt and review of comments, an Exposure Draft is produced for public comment; Following the receipt and review of comments, the final IFRS will be issued. CIMA F1 5
Scope and application of IFRSs Any limitation of the applicability of a specific IFRS is made clear within that standard. IFRSs are not intended to be applied to immaterial items, nor are they retrospective. Within each individual country local regulations will govern, to a greater or lesser degree. CIMA F1 6
Topic 7: The Conceptual Framework A1a: Explain the need for the regulation of the financial reporting information of incorporated entities and the key elements of an ethical regulatory environment for such information Purpose and status of the conceptual Framework The IASB s Framework for the Preparation and Presentation of Financial Statements sets out the concepts underlying the preparation and presentation of financial statements for external users. In detail, the intended role of the Framework is to: assist the IASB in its development of future accounting standards and in its review of existing accounting standards assist the IASB by providing a basis for reducing the number of alternative accounting treatments permitted by law and accounting standards assist preparers of financial statements in applying accounting standards and in dealing with topics that do not form the subject of an accounting standard assist auditors in forming an opinion as to whether financial statements conform with accounting standards help users of financial statements to interpret the information contained in financial statements prepared in conformity with accounting standards provide those who are interested in the work of the IASB with information about its approach to the formulation of accounting standards. The Framework is not itself an accounting standard nor can it override the requirements of any existing accounting standard. The objective general purpose financial reporting You must learn the objective of financial statements, the qualitative characteristics of financial statements and the underlying assumptions. These are a need to learn. At the user The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. These decisions involve buying, selling or holding investments in shares or debt instruments, and providing or settling loans and other forms of credit. CIMA F1 7
Decisions made by users depend upon the returns that they expect to receive, for example dividend income, principal and interest payments or market price increases. Consequently users need information that helps them assess the prospects for future net cash inflows to an entity. To assess the entity's prospects for future net cash inflows users need information about: the resources of the entity claims against the entity how efficiently and effectively the entity's management and governing board have discharged their responsibilities to use the entity's resources. Many existing and potential investors, lenders and other creditors cannot require reporting entities to provide information directly to them and must rely upon general purpose financial reports for much of the financial information they need. Consequently they are the primary users to whom general purpose financial reports are directed. Underlying assumption Going concern Going concern is the underlying assumption adopted whenever we are preparing financial statements. You will have learnt about this from your first introduction to double-entry bookkeeping. Although the accruals concept is no longer considered to be an underlying assumption it is still covered by the Conceptual Framework as an important concept of financial accounting. The accruals concept states events should be dealt with in the accounting period they occur, rather than the period they are paid. Fundamental qualitative characteristics of financial statements The framework splits qualitative characteristics into two categories: (i) Fundamental qualitative characteristics - Relevance - Faithfull representation (ii) Enhancing qualitative characteristics: - Comparability - Verifiability - Timeliness - Understandability CIMA F1 8
Relevance Relevance to be useful, information must be relevant to the decision making needs of the user. Information is relevant when it influences the economic decisions of users by helping them to evaluate past, present or future events or confirming or correcting their past evaluations. The relevance of information is affected by its nature and materiality. (Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements) Faithful representation Faithful representation a transaction or other event is faithfully represented if the way in which it is recognised, measured or presented in the financial statements corresponds closely to the effect of that transaction or event. Substance over form the economic substance of a transaction should be recorded rather than simply its legal form. Example: A company acquired a non-current asset under a hire purchase agreement; the legal position is that ownership does not pass until the final instalment has been paid. However, substance of the transaction is that the company is purchasing an asset and taking out a loan to pay for it. Therefore, the asset and the loan are recorded in the accounts. Neutrality (objectivity) information is not neutral if it has been selected or presented in such a way as to influence the making of a decision or judgement in order to achieve a predetermined result or outcome. Free from error Within the bounds of materiality information must be free from error. This does not mean perfectly accurate. Estimates are acceptable but must be described clearly as such. Completeness- Financial information must be complete, within the restrictions of materiality and cost, to be reliable. Omission may cause information to be misleading. Enhancing qualitative characteristics of financial statements Comparability, verifiability, timeliness and understandability are qualitative characteristics that enhance the usefulness of information that is relevant and faithfully represented. The enhancing qualitative characteristics may also help determine which of two ways should be used to depict a phenomenon if both are considered equally relevant and faithfully represented. CIMA F1 9
Comparability Users must be able to compare financial statements over a period of time in order to identify trends in financial position and performance. Users must also be able to compare financial statements of different entities to be able to assess their relative financial position and performance. In order to achieve comparability, similar items should be treated in a consistent manner from one period to the next and from one entity to another. However, it is not appropriate for an entity to continue accounting for transactions in a certain manner if alternative treatments exist that would be more relevant and reliable. Disclosure of accounting policies should also be made so that users can identify any changes in these policies or differences between the policies of different entities. Verifiability Verification can be direct or indirect. Direct verification means verifying an amount or other representation through direct observation i.e. counting cash. Indirect verification means checking the inputs to a model, formula or other technique and recalculating the outputs using the same methodology i.e. recalculating inventory amounts using the same cost flow assumption such as first-in, first-out method. Timeliness Timeliness means having information available to decision makers in time to be capable of influencing their decisions. Generally, the older the information is the less useful it becomes. Understandability Information needs to be readily understandable by users. Information that may be relevant to decision making should not be excluded on the grounds that it may be too difficult for certain users to understand. CIMA F1 10
The elements of financial statements Asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. Liabilities are an entity s obligations to transfer economic benefits as a result of past transactions or events. Equity is the residual amount found by deducting all liabilities of the entity from all of the entity s assets. Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from equity participants. Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. CIMA F1 11
Recognition of the elements of financial statements In order to recognise anything in the statement of financial position and income statement it must meet all three of the following criteria: Meet the definition of the element (as above) Probable future economic benefit will flow to or from the entity The item can be measured reliably Measurement of the elements of financial statements Historical cost --- cash price or fair value at acquisition or obligation. Most commonly used but widely criticised Current cost what would be the cash price today Realisable value --- what could be realised/satisfied today Present value discounted future cash flows The Framework does not state which of the four should be used Concepts of capital and capital maintenance. The concept of capital maintenance is concerned with how an entity defines the capital that it seeks to maintain. It provides the linkage between the concepts of capital and the concepts of profit because it provides the point of reference by which profit is measured; it is a prerequisite for distinguishing between an entity s return on capital and its return of capital; only inflows of assets in excess of amounts needed to maintain capital may be regarded as profit and therefore as a return on capital. Hence, profit is the residual amount that remains after expenses (including capital maintenance adjustments, where appropriate) have been deducted from income. If expenses exceed income the residual amount is a loss. Financial capital maintenance is measured in either nominal monetary units or units of constant purchasing power. Physical capital maintenance requires the adoption of the current cost basis of measurement an appreciation of what it would cost to replace assets at current prices. The main difference between the two is how they treat the effects of increases in prices of assets and liabilities. CIMA F1 12
Apply Your Knowledge 1 Under the IASB s Framework for the preparation and presentation of financial statements which of the following is the threshold quality of useful information. A. Relevance B. Reliability C. Materiality D. Understandability Apply Your Knowledge 2 THE IASB s Framework identifies qualitative characteristics i. Relevance ii. Comparability iii. Verifiability iv. Understandability v. Faithful Representation Which of the above are not listed as an enhancing characteristic? A. (i),(iv) and (v) B. (ii),(iii) and (iv) C. (ii) and (iii) D. (i) and (v) Apply Your Knowledge 3 According to The Framework what is the main objective of financial reporting? Providing useful information to: A. The government B. The employees C. The customers D. The investors CIMA F1 13
Apply Your Knowledge 4 Which THREE of the following are uses of financial statements as identified by The Framework? A. The general public B. Trade unions C. Lenders D. Analyst/ advisors E. The European Union F. Competitors Apply Your Knowledge 5 Which are the THREE main financial statements as identified by The Framework? A. The statement of liabilities B. The statement of expenses C. The income statement D. The statement of financial position E. The statement of cash flows F. The statement of Obligations Apply Your Knowledge 6 According to The Framework which qualitative characteristics enhance the usefulness of information that is: A. Comparability, understandability, timeliness, completeness B. Consistency, prudence, measureability, verifiability C. Consistency, reliability, measurability, timeliness D. Materiality, understandability, measureability, reliability CIMA F1 14
Apply Your Knowledge 7 Which THREE of the following are qualitative characteristics of financial statements as identified by A. Relevance B. Materiality C. Reliability D. Timeliness E. Measurability F. Prudence Apply Your Knowledge 8 Which THREE of the following are elements of financial statements as identified by The Framework A. Revenue B. Expenses C. Profits D. Losses E. Capital F. Obligations CIMA F1 15