The regulatory and conceptual framework

Chapter learning objectives

Upon completion of this chapter you will be able to:

 explain the regulatory system:

o International Accounting Standards Committee (IASC) Foundation
o International Accounting Standards Board (IASB),
o the Standards Advisory Council (SAC) and
o 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:
o relevance (including materiality)
o reliability (including faithful representation, substance over form,
neutrality, prudence and completeness)
o comparability
o understand ability

 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:
o going concern
o accruals
o consistency
o materiality
o substance over form
o prudence

 explain the advantages and disadvantages of historical cost accounting (HCA)

in times of changing prices
 explain in principle the main alternatives to HCA:
o replacement cost
o net realisable value
o 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:
o develop, in the public interest, a single set of high-quality accounting
standards
o promote the use and rigorous application of those standards
o 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 Preparing Financial
Statements examination is the International Accounting Standards Board (IASB)
which has issued a number of authoritative IASs and IFRSs.

Structure of the International Accounting Standards Board

International Financial Reporting Interpretations Committee (IFRIC)

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

Standards Advisory Council

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

Benchmark and allowed alternative treatments

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

Generally accepted accounting practice (GAAP)

You may come across the expression generally accepted accounting practice (GAAP).
This means the set of accounting practices applied in a given country or context. For
an individual country, GAAP is a combination of legislation, accounting standards,
stock exchange requirements and, in areas where detailed rules do not exist, other
acceptable accounting practices. Thus one may speak of ˜UK GAAP or US GAAP. In
an international context, GAAP means accounting practice as defined in IASs, with
each country adding its own local requirements and practices.
3 The conceptual framework

The framework for the preparation and presentation of financial statements sets out
the concepts that underlie financial statements for external 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

The accruals basis of accounting means that the effects of transactions and other events
are recognised as they occur and not as cash or its equivalent is received or paid.

(2) the going concern basis.

The going concern basis assumes that the entity has neither the need nor the intention
to liquidate or curtail materially the scale of its operations.

These also appear in IAS 1.

Faithful representation
There is no absolute definition of fair presentation (known as the true and fair view in
the UK). It is felt that its meaning evolves over 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 conclude that

compliance with an IFRS or interpretation would be misleading.

In this case an entity should depart from the requirement of the standard provided
the relevant regulatory framework permits such departure.

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 set of attributes which

together make the information in the financial statements 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 the qualitative characteristics can be
satisfied, and therefore there will be 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.

 Understand ability and completeness

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

 Relevance and reliability 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 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.

7 Historical cost
The limitations of historical cost accounting

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

Liabilities are recorded at the amount of proceeds received in exchange 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 has been based on historical
cost accounting. Under historical cost accounting, assets are recorded at the amount
of cash or cash equivalents paid, or the fair value of the consideration given for them.

Liabilities are recorded at the amount of proceeds received in exchange 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 cost figures provide a basis for comparison with the results
of other companies for the same period or similar periods, with the results of the same
company for previous periods and with budgets.

(5) Lack of acceptable alternatives.

Disadvantages of historical cost accounting

(1) It overstates profits when prices are rising through inflation. Several factors
contribute to this. For example, if assets are retained at their original cost, depreciation
is based on that cost. As inflation pushes prices up, the true value to the enterprise of
the use of the asset becomes progressively more than the depreciation 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 net assets. If the whole
of that profit is distributed as dividend by a company, or withdrawn by a sole trader,
the enterprise has the same capital at the end of the year as it had at the beginning. In
other words, it has maintained its financial capital. However, it will not have
maintained its physical capital if prices have risen through inflation during the year,
because the financial capital will not buy the same inventory and other assets to enable
the enterprise to continue operating at the same level.

(3) The statement of financial position does not show the value of the enterprise. A
statement of financial position summarises the assets and liabilities of the enterprise,
but there are several reasons why it does not represent the true value of the enterprise.
One reason for this could be that the use of 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 in the statement of
financial position internally generated goodwill does not appear.)

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

(5) It does not recognise the loss suffered through holding monetary assets while
prices are rising. An enterprise holding cash or receivables through a period of
inflation suffers 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 the value of the assets less liabilities to
the enterprise. When prices are changing, however, there are problems.

Depreciation

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

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

(1) The depreciation charge is based on the original cost of the asset measured in terms
of historical, whereas the revenues against which depreciation is matched are
measured in terms of current $s. The profit figure we calculate is not meaningful as it
ignores price changes which have taken place since the asset was purchased.
(2) Although the concept of depreciation ensures that the capital of the enterprise is
maintained intact in money terms, it does not ensure that the capital of the enterprise
is maintained intact in real terms (see examples below).

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

Example 1

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

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

Inventory and cost of sales

Assume a company values inventory on a historical cost basis using the FIFO method.
During a period of inflation the effect of this method 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, it would not
be maintaining the capital of the enterprise intact in real terms.

Example 2

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

Under HCA the profit for the three months is KSh 650 (KSh1,650 - KSh1,000). If the
proprietor withdraws this profit, the closing statement of financial position at 31
March would show capital account KSh 1,000represented by cash of KSh 1,000.

Although capital has been maintained intact in money terms (it was KSh 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 compare the results of the
enterprise over a number of years so that trends could be identified. Thus, if sales were
KSh 100,000 four years ago and KSh 130,000 in the current year, we could conclude
that sales have increased by 30%. However, in real terms the increase may not be this
amount, as price levels may have changed in the previous four years. If price levels
have risen by 40% in the last four years, then the sales should be KSh 140,000 in the
current year in order to maintain the real value 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 the historical 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