Chapter 21: The regulatory and conceptual framework

Chapter learning objectives

Upon completion of this chapter you will be able to:

• explain the regulatory system:
  • International Accounting Standards Committee (IASC) Foundation
  • International Accounting Standards Board (IASB),
  • the Standards Advisory Council (SAC) and
  • the International Financial Reporting Interpretations Committee (IFRIC)

• explain how International Financial Reporting Standards (IFRSs) affect the financial reporting process
• explain the meaning of the qualitative characteristics of financial reporting and define and apply each of the following:
  • relevance (including materiality)
  • reliability (including faithful representation, substance over form, neutrality, prudence and completeness)
  • comparability
  • understandability

• illustrate the problems of achieving a balance between the qualitative characteristics
• explain the meaning of accounting concepts and define and apply each of the following:
  • going concern
  • accruals
  • consistency
  • materiality
  • substance over form
  • prudence

• explain the advantages and disadvantages of historical cost accounting (HCA) in times of changing prices
• explain in principle the main alternatives to HCA:
  • replacement cost
  • net realisable value
  • economic value.

1 The regulatory framework

The need for regulation

• Regulation ensures that accounts are sufficiently reliable and useful, and prepared without unnecessary delay.
• Financial accounts are used as the starting point for calculating taxable profits.
• The annual report and accounts is the main document used for reporting to shareholders on the condition and performance of a company.
• The stock markets rely on the financial statements published by companies.
• International investors prefer information to be presented in a similar and comparable way, no matter where the company is based.

The role of international accounting standards

• International accounting standards are the rules that govern accounting for transactions.
• They don’t have the force of law. They are effective only if adopted by the national regulatory bodies.

2 The role and structure of the IASB

• The IASC Foundation is the supervisory body. Its objective is to:
  • develop, in the public interest, a single set of high-quality accounting standards
  • promote the use and rigorous application of those standards
  • bring about the convergence of national accounting standards and international accounting standards.

• The IASB is responsible for issuing new International Financial Reporting Standards (IFRSs).
• The IFRIC issue rapid guidance where there are differing interpretations of IASs/IFRSs.
• The SAC advises the IASB in developing new accounting standards.

The regulatory framework

The regulatory framework

The main source of regulations for the purpose of the ACCA’sPreparing Financial Statements examination is the InternationalAccounting Standards Board (IASB) which has issued a number ofauthoritative IASs and IFRSs.

Structure of the International Accounting Standards Board

International Financial Reporting Interpretations Committee (IFRIC)

The IFRIC’s main task is to interpret the application of IASsand IFRSs if difficulties arise. They may issue Draft Interpretationsfor public comment before finalising an Interpretation. They report tothe IASB and must obtain Board approval for their Interpretations beforeissue.

Standards Advisory Council

The SAC exists to provide the IASB with advice on majorstandard-setting projects and other matters. It has about 50 members,including representatives of national standard setters and otherinterested parties.

Benchmark and allowed alternative treatments

An IAS sometimes contains more than one permitted accountingtreatment for a transaction or event. One of them may be designated thebenchmark treatment. The other treatments, if acceptable, are classifiedas allowed alternative treatments. The IASB tries to limit the numberof alternative treatments allowed in an IAS, and thus tries to minimisethe number of Standards containing allowed alternative treatments.

Generally accepted accounting practice (GAAP)

You may come across the expression generally accepted accountingpractice (GAAP). This means the set of accounting practices applied in agiven country or context. For an individual country, GAAP is acombination of legislation, accounting standards, stock exchangerequirements and, in areas where detailed rules do not exist, otheracceptable accounting practices. Thus one may speak of ‘UK GAAP’ or‘US GAAP’. In an international context, ‘GAAP’ means accountingpractice as defined in IASs, with each country adding its own localrequirements and practices.

3 The conceptual framework

The framework for the preparation and presentation of financialstatements sets out the concepts that underlie financial statements forexternal users. It is designed to:

• assist the Board of the IASB in developing new standards and reviewing existing ones
• assist in harmonising accounting standards and procedures
• assist national standard-setting bodies in developing national standards
• assist preparers of financial statements in applying IASs/IFRSs and in dealing with topics not yet covered by IASs/IFRSs
• assist auditors in forming an opinion as to whether financial statements conform with IASs/IFRSs
• assist users of financial statements in interpreting financial statements
• provide those interested in the work of the IASB with information about its approach to the formulation of IFRSs.

The scope of the framework

The framework deals with:

• 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 (not examinable at this level).
• concepts of capital and capital maintenance (not examinable at this level).

Underlying assumptions of the framework

The framework identifies two underlying assumptions:

(1) the accruals basis of accounting

(2) the going concern basis.

Faithful representation

There is no absolute definition of fair presentation (known asthe true and fair view in the UK). It is felt that its meaning evolvesover time and with changes in generally accepted accounting practice(GAAP).

When do financial statements show fair presentation?

Financial statements will generally show a fair presentation when:

• they conform with accounting standards
• they conform with the any relevant legal requirements
• they have applied the qualitative characteristics from the Framework.

True and fair override

IAS 1 states that an entity whose financial statements comply with IFRSs should disclose that fact.

However in extremely rare circumstances management may concludethat compliance with an IFRS or interpretation would be misleading.

In this case an entity should depart from the requirement of thestandard provided the relevant regulatory framework permits suchdeparture.

 4 Objectives of financial statements

The objective of financial statements is to provide information about:

• the financial position of an entity (provided mainly in the statement of financial position)
• the financial performance (provided mainly in the statement of comprehensive income) and
• changes in the financial position of an entity (provided in the statement of changes in equity and statement of cash flows)

that is useful to a wide range of users in making economic decisions.

Interest parties

User groups

• equity investors (existing and potential)
• existing lenders and potential lenders
• employees
• stock market analysts and advisers
• business contacts including customers, suppliers and competitors
• the government, including the tax authorities
• the general public.

5 Qualitative characteristics of financial statements

The qualitative characteristics of financial statements are a setof attributes which together make the information in the financialstatements useful to users.

Qualitative characteristics

Problems of achieving a balance between the qualitative characteristics

At any given point in time it is unlikely that all of thequalitative characteristics can be satisfied, and therefore there willbe conflicts between them. Examples are as follows:

• Relevance and timeliness

  If financial statements are to be tailored to the needs of each individual user, then they will take longer to prepare.

• Understandability and completeness

  If all aspects of the business are to be shown, this may make the financial statements less comprehensible.

• Relevance and reliability â€“ sometimes the information that is most relevant is not the most reliable or vice versa. In such conflicts, the information that is most relevant of the information that is reliable should be used.

  This conflict might also arise over the timeliness of information, e.g. a delay in providing information can make it out of date and so affect its relevance, but reporting on transactions before uncertainties are resolved may affect the reliability of the information. Information should not be provided until it is reliable.

• Neutrality and prudence â€“ neutrality requires information to be free of deliberate or systematic bias while prudence is a potentially biased concept towards not overstating gains or assets or understating losses or liabilities. Neutrality and prudence are reconciled by finding a balance that ensures that the deliberate and systematic overstatement of assets and gains and understatement of losses and liabilities do not occur.

6 Other accounting principles

These generally recognised principles underlie accounting and financial statements.

Test your understanding 1

Which of the following statements are correct?

(1) Materiality means that only tangible items may be recognised as assets.

(2) Substance over form means that thecommercial effect of a transaction must always be shown in the financialstatements even if this differs from legal form.

(3) A business may only change an accounting policy to achieve a fairer representation.

A 2 and 3 only

B All of them

C 1 and 2 only

D 1 and 3 only

 7 Historical cost

The limitations of historical cost accounting

Under historical cost accounting, assets are recorded at theamount of cash or cash equivalents paid, or the fair value of theconsideration given for them.

Liabilities are recorded at the amount of proceeds received inexchange for the obligation. This method of accounting has advantages,but it also has serious disadvantages.

Advantages and disadvantages of historical cost accounting

The limitations of historical cost accounting

Introduction

Virtually everything you have studied so far in this book hasbeen based on historical cost accounting. Under historical costaccounting, assets are recorded at the amount of cash or cashequivalents paid, or the fair value of the consideration given for them.

Liabilities are recorded at the amount of proceeds received inexchange for the obligation. This method of accounting has advantages,but it also has serious disadvantages.

Advantages of historical cost accounting

(1) Records are based on objectively verifiable amounts (actual cost of assets, etc.)

(2) It is simple and cheap.

(3) The profit concept is well understood.

(4) Within limits, historical costfigures provide a basis for comparison with the results of othercompanies for the same period or similar periods, with the results ofthe same company for previous periods and with budgets.

(5) Lack of acceptable alternatives.

Disadvantages of historical cost accounting

(1) It overstates profits when pricesare rising through inflation. Several factors contribute to this. Forexample, if assets are retained at their original cost, depreciation isbased on that cost. As inflation pushes prices up, the true value to theenterprise of the use of the asset becomes progressively more than thedepreciation charge.

This disadvantage can be overcome by revaluing non-current assets.IAS 16 then requires depreciation to be based on the revalued amount.

(2) It maintains financial capital but does not maintain physical capital.

If an enterprise makes a profit it must necessarily have more netassets. If the whole of that profit is distributed as dividend by acompany, or withdrawn by a sole trader, the enterprise has the samecapital at the end of the year as it had at the beginning. In otherwords, it has maintained its financial capital. However, it will nothave maintained its physical capital if prices have risen throughinflation during the year, because the financial capital will not buythe same inventory and other assets to enable the enterprise to continueoperating at the same level.

(3) The statement of financialposition does not show the value of the enterprise. A statement offinancial position summarises the assets and liabilities of theenterprise, but there are several reasons why it does not represent thetrue value of the enterprise. One reason for this could be that the useof historical cost accounting means that assets are included at costless depreciation based on that cost rather than at current value.(Another reason is, of course, that not all the assets are included inthe statement of financial position– internally generated goodwilldoes not appear.)

(4)It provides a poor basis forassessing performance. The profit is overstated as explained in (1),while assets are understated as discussed in (3) above. The result isthat return on capital employed is doubly distorted and exaggerated.

(5)It does not recognise the losssuffered through holding monetary assets while prices are rising. Anenterprise holding cash or receivables through a period of inflationsuffers a loss as their purchasing power declines.

The impact of changing prices

When prices are not changing, historical cost accounting (HCA)does accurately and fairly show profits made by the enterprise and thevalue of the assets less liabilities to the enterprise. When prices arechanging, however, there are problems.

Depreciation

Under a system of HCA, the purpose of depreciation is simply toallocate the original cost (less estimated residual value) of anon-current asset over its estimated useful life. If depreciation ischarged in the income statement, then by reducing the amount which canbe paid out as a dividend, funds are retained within the company ratherthan paid to the shareholders. When the time comes to replace the asset,management must ensure that those funds are available in a sufficientlyliquid form.

When inflation is taken into account, we can note that:

(1) The depreciation charge is basedon the original cost of the asset measured in terms of historical $s,whereas the revenues against which depreciation is matched are measuredin terms of current $s. The profit figure we calculate is not meaningfulas it ignores price changes which have taken place since the asset waspurchased.

(2) Although the concept ofdepreciation ensures that the capital of the enterprise is maintainedintact in money terms, it does not ensure that the capital of theenterprise is maintained intact in real terms (see examples below).

The accumulated depreciation at the end of the asset’s useful life will fall short of its replacement cost.

Example 1

An enterprise starts off with $1,000 cash and buys two machinesat a cost of $500 each. All profits are distributed to the owners. Atthe end of ten years the company has no machines and $1,000 cash. Thusthe capital of the enterprise has been maintained intact in money terms.Suppose at the end of ten years the current replacement cost of onemachine is $1,000. Therefore the $1,000 cash at the end of the ten yearswill buy only one machine. In real terms, the capital at the end of theperiod is half that at the beginning of the period.

Profit has been over-distributed. If profit is a true surplus, theowners should be able to withdraw all the profit and be in exactly thesame position as before in real terms.

Inventory and cost of sales

Assume a company values inventory on a historical cost basisusing the FIFO method. During a period of inflation the effect of thismethod is to overstate the real profit of the enterprise, since sales(in current terms) are matched with cost of sales (in historical terms).If the company distributed the whole of its historical cost profit, itwould not be maintaining the capital of the enterprise intact in realterms.

Example 2

An enterprise starts off on 1 January 20X7 with $1,000 cash(contributed by the proprietor). On the same day it purchases 500 motorsat $2 each. These are sold on 31 March 20X7 for proceeds of $1,650. Atthis date the replacement cost of an identical motor is $2.20.

Under HCA the profit for the three months is $650 ($1,650 –$1,000). If the proprietor withdraws this profit, the closing statementof financial position at 31 March would show capital account $1,000represented by cash of $1,000.

Although capital has been maintained intact in money terms (it was$1,000 at 1 January), it has not been maintained intact in real terms.At 31 March $1,000 cash will buy only 455 (approximately!) motors.

Comparability of data over time

Example 3

We saw earlier a need for users of accounts to be able to comparethe results of the enterprise over a number of years so that trendscould be identified. Thus, if sales were $100,000 four years ago and$130,000 in the current year, we could conclude that sales haveincreased by 30%. However, in real terms the increase may not be thisamount, as price levels may have changed in the previous four years. Ifprice levels have risen by 40% in the last four years, then the salesshould be $140,000 in the current year in order to maintain the realvalue of sales. There has therefore been a real decline.

Alternatives to historical cost accounting

Alternatives to historical cost accounting

• Replacement cost involves recording assets at the cost of replacing them. An advantage is that the replacement cost is more up to date than the historical cost.
• Net realisable value assets and liabilities are carried at the amount which could currently be obtained by an orderly disposal. Assets are recorded at the amount after deducting the actual/expected disposal costs. Liabilities are recorded at their settlement values.
• Economic value involves recording assets at the value of keeping them in the business. i.e. not disposing of them. Assets recorded in this way are normally carried at the present value of the future discounted net cash flows. Liabilities are recorded at their discounted net present values.

Test your understanding 2

In a time of rising prices, what effect does the use of thehistorical cost concept have on an entity’s profit and asset values?

A Both profit and asset values are understated

B Profit is understated and asset values overstated

C Profit is overstated and asset values understated

D Both profit and asset values are overstated

Chapter summary

Test your understanding answers

Test your understanding 1

The correct answer is A

Test your understanding 2

The correct answer is C

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