ACCA: FINANCIAL REPORTING [FR]

CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING

Purpose Of Framework
 Previous accounting standards had conflicts with each other.
 Assist in the development of future IFRS and the review of existing standards
 Assist the preparers of financial statements in dealing with accounting transactions for
which there is not (yet) an accounting standard
 To assist national standard setting bodies in developing national standards and/or
harmonizing existing accounting practices.

QUALITATIVE CHARACTERISTICS OF USEFUL

FINANCIAL INFORMATION
Fundamental qualitative characteristics:
Relevance
Relevant financial information is capable of making a difference in the decisions made by
users.
Relevance of information is affected by its materiality. Information is material if its
omission or misstatement could influence the economic decision of the user taken on the
basis of financial statement.
Materiality is an entity-specific aspect of relevance based on the nature or magnitude (or
both) of the items to which the information relates in the context of an individual entity's
financial report

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 ACCA: FINANCIAL REPORTING [FR]
Faithful representation
General purpose financial reports represent economic phenomena in words and numbers.
To be useful, financial information must not only be relevant, it must also represent
faithfully the phenomena it purports to represent. Faithful representation means
representation of the substance of an economic phenomenon instead of representation of
its legal form only. Faithful representation has three charactersitcs:
 Complete
 Neutral
 Free from error.

Enhancing qualitative characteristics:

Comparability:
Information about a reporting entity is more useful if it can be compared with a similar
information about other entities and with similar information about the same entity for
another period or another date. Comparability enables users to identify and understand
similarities in, and differences among, items.

Verifiability
Verifiability helps to assure users that information represents faithfully the economic
phenomena it purports to represent. Verifiability means that different knowledgeable and
independent observers could reach consensus, although not necessarily complete
agreement, that a particular depiction is a faithful representation.

Timeliness
Timeliness means that information is available to decision-makers in time to be capable of
influencing their decisions.

Understandability
Classifying, characterising and presenting information clearly and concisely makes it
understandable. While some phenomena are inherently complex and cannot be made
easy to understand, to exclude such information would make financial reports incomplete
and potentially misleading. Financial reports are prepared for users who have a reasonable
knowledge of business and economic activities and who review and analyse the
information with diligence.

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 ACCA: FINANCIAL REPORTING [FR]
ELEMENTS OF FINANCIAL STATEMENTS
ASSETS:
2010 Framework Definition:
An asset is a:
 Resource
 controlled by an entity
 As a result of past event
 From which future economic benefits are expected to flow to an entity

2018 Framework Definition:

An asset is a:
 Economic Resource
 controlled by an entity
 As a result of past event

What is meant by economic resource?

A right that has the potential to produce economic benefits.

LIABILITIES:
2010 Framework Definition:
A liability is a:
 Present obligation
 Arising from past events
 Settlement of which is expected to result in an outflow of resources embodying
economic benefits.
2018 Framework Definition:
A liability is a:
 Present obligation
 To transfer an economic resource
 As a result of past event

What is meant by obligation?

A duty or responsibility that an entity has no practical ability to avoid.

EQUITY:
Equity is the residual interest in the assets of the entity after deducting all its liabilities.

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 ACCA: FINANCIAL REPORTING [FR]
INCOME:
Income is the:
 Increase in assets; or
 Decrease in liabilities
that results in increase in equity, OTHER THAN those relating to contributions from
owners.

EXPENSE:
Expense is the:
 Decrease in assets; or
 Increase in liabilities
that results in decrease in equity, OTHER THAN those relating to distribution to owners.

RECOGNITION OF THE ELEMENTS OF FINANCIAL

STATEMENTS
Recognition is the process of incorporating in the statement of financial position or
statement of profit or loss.
2010 Framework Recognition Criteria
 The item that meets the definition of an element
 It is probable that any future economic benefit associated with the item will flow to or
from the entity and
 The item’s cost or value can be measured with reliability.

2018 Framework Recognition Criteria

The Board has confirmed a new approach to recognition, which requires decisions to be made
by reference to the qualitative characteristics of financial information. The Board has confirmed
that an entity should recognise an asset or a liability (and any related income, expense or
changes in equity) if such recognition provides users of financial statements with:

 relevant information about the asset or the liability and about any income, expense or
changes in equity
 a faithful representation of the asset or liability and of any income, expenses or changes in
equity, and
 information that results in benefits exceeding the cost of providing that information

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 ACCA: FINANCIAL REPORTING [FR]
A key change to this is the removal of a ‘probability criterion’. This has been removed as
different financial reporting standards apply different criterion; for example, some apply
probable, some virtually certain and some reasonably possible. This also means that it will not
specifically prohibit the recognition of assets or liabilities with a low probability of an inflow or
outflow of economic resources.

MEASUREMENTS OF ELEMENTS IN FINANCIAL

STATEMENTS
The IFRS Framework acknowledges that a variety of measurement bases:
Historical cost=>> The actual amount of cash paid or consideration given for the item
Current cost=>> Assets are carried at the amount of cash or cash equivalents that would
have to be paid if the same or an equivalent asset was acquired currently
Net realisable value=>> The amount of cash or cash equivalents that could currently
be obtained by selling an asset in an orderly disposal
Present value / Economic Value=>> A current estimate of the present discounted
value of the future net cash flows in the normal course of business
Fair Value=>> As per IFRS 13

EXAMPLE MEASUREMENT BASES

A company owns a machine which it purchased four years ago for $100,000. The accumulated
depreciation on the machine to date is $40,000. The machine could be sold to another
manufacturer for $50,000 but there would be dismantling costs of $5,000. To replace the
machine with a new version would cost $110,000. The cash flows from the existing machine are
estimated to be $25,000 for the next two years followed by $20,000 per year for the remaining
four years of the machine's life. The relevant discount rate for this company is 10% and the
discount factors are:
Year 1: 0.909 Year 2: 0.826 Years 3–6 inclusive 2.619 (annuity rate)
Calculate the following values for the machine:
 Historical cost
 Net realisable value
 Current Cost
 Economic value

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 ACCA: FINANCIAL REPORTING [FR]
HISTORICAL COST
Cost 100,000
Less: Accumulated Depreciation (40,000)
60,000
NET REALISAABLE VALUE
Selling Price 50,000
Less: Costs to sell (5,000)
45,000
CURRENT COST
Replacement cost for new asset 110,000
Less: 4 years’ depreciation (4 × 1/10 × $110,000) (44,000)
66,000
ECONOMIC VALUE
$25,000*0.909 22,725
$25,000*0.826 20,650
$20,000*2.619 52,380
95,755

HISTORICAL COST ACCOUNTING

Advantages
 Simple to understand
 Figures are objective, reliable and verifiable
 Results in comparable financial statements
 There is less possibility for manipulation by using 'creative accounting' in asset
valuation.

Disadvantages
 The carrying value of assets is often substantially different to market value
 No account is taken of inflation meaning that profits are overstated and assets
understated, ultimately resulting in distorted ratios such ROCE.
 Comparability of figures is not accurate as past figures are not restated for the effects
of inflation

EXAMPLE
Company A acquires a new machine in 20X4. This machine costs $50,000 and has an
estimated useful life of ten years.
Company B acquires an identical one-year old machine in 20X5. The cost of the machine
is $48,000 and it has an estimated useful life of nine years.
Depreciation charges (straight-line basis, nil residual value) in 20X5 are as follows.
Company A $50,000/10 = $5,000
Company B $48,000/9 = $5,333
Carrying amounts at the end of 20X5 are:

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 ACCA: FINANCIAL REPORTING [FR]
Company A $50,000 – (2 × $5,000) = $40,000
Company B $48,000 – $5,333 = $42,667
Both companies are using identical machines during 20X5, but the statements of profit
or loss will show quite different profit figures because of adherence to historical cost.

ALTERNATIVES TO HISTORICAL COST ACCOUNTING

As historical cost accounting has been criticized for providing information that is out of date
and potentially understates asset values, current value accounting has arisen as an alternative.
This largely takes two forms:
 constant purchasing power (CPP), or
 current cost accounting (CCA).

CONSTANT PURCHASING POWER ACOUNTING (CPP)

The key features of CPP are as follows:
• Accounts figures are adjusted to show all figures in terms of money with the same
purchasing power.
• A general price index is used for this, applying a general level of inflation.
• Figures in the statement of profit or loss and statement of financial position are adjusted by
the CPP factor.
• CPP factor = (Index at the reporting date/Index at date of initial recognition)
ADVANTAGES
 CPP accounting is both simple and objective. It relies on a standard index.
 It adjusts for changes in the unit of measurement and therefore is a true system of inflation
accounting.
 It measures the impact on the company in terms of shareholders’ purchasing power.

DISADVANTAGES
 It fails to capture economic substance when specific and general price movements diverge
 The unfamiliarity of information stated in terms of current purchasing power units.
 CPP does not show the current values to the business of assets and liabilities
 The general price index used is not necessarily appropriate for all assets in all businesses

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 ACCA: FINANCIAL REPORTING [FR]
CURRENT COST ACOUNTING (CCA)
The key features of CCA are as follows:
 It is based on deprival values or value to the business.
 Inventory and non-current assets are valued at deprival value.
 Monetary assets (cash, receivables, payables, loans) are not adjusted.
 An additional charge to the statement of profit or loss reflects the deprival value of
inventory within cost of sales.
 An additional charge in the statement of profit or loss reflects deprival value of non-current
assets (depreciation).

ADVANTAGES
 The most important advantage of CCA is its relevance to users.
 Users will be able to assess the current state or recent performance of the business.
 Assets are stated at their value to the business.
DISADVANTAGES
 Possibly greater subjectivity and lower reliability than historical cost.
 Lack of familiarity.
 Complexity.
 CCA only adjusts values for non-monetary assets not all assets/liabilities.

CAPITAL MAINTENANCE
Capital maintenance is a theoretical concept which tries to ensure that excessive dividends are
not paid in times of changing prices. Capital maintenance concepts can be classified as follows:
 Physical capital maintenance (PCM), alternatively known as operating capital maintenance
(OCM).
 Financial capital maintenance (FCM).

PHYSICAL CAPITAL MAINTENANCE (PCM)

PCM sets aside profits in order to allow the business to continue to operate at current levels of
activity. In practice, this tends to mean adjusting opening capital by SPECIFIC price changes.
Example
Business starts on 1 Jan X1 with contribution of $1,000 from owners. This is used to purchase
100 units at $10 each, which are sold for $1,100 cash. Opening capital is $1,000 and closing is
$1,100 so profit is usually measured as $100.
However, over the year, the price of the units has increased to $10.75 (a specific price change
hitting the business, rather than general). This is a price increase of 7.5%.
Therefore, increase opening capital by 7.5% × 1000 = $1,075
Profit is therefore $1,100 – 1,075 = $25
Even if the profit is paid out, the business is left with cash of $1,075. This is enough to buy 1000
more units at $10.75 each. In other words, the productive capacity of the business, or physical
capital, has been maintained.

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 ACCA: FINANCIAL REPORTING [FR]
Example
If price rises were 15% ($11.50), then the adjusted opening capital = 115% × $1000 = $1,150. So
the profit of the business is $1,100 – $1,150 = $50 loss
Business has cash of $1,100 as there are no profits to pay out – can only purchase 95 units at
$11.50 i.e. productive capacity has deteriorated.

FINANCAIL CAPITAL MAINTENANCE (FCM)

FCM sets aside profits in order to preserve the value of shareholders’ funds in ‘real terms’, i.e.
after inflation.
We can measure the increase in monetary terms (money financial capital) or in terms of
constant purchasing power (real financial capital):
Monetary terms
 Business starts on 1 Jan X1 with contribution of $1,000 from owners. This is used to
purchase 100 units at $10 each, which are sold for $1,100 cash.
 Opening capital is $1,000 and closing is $1,100 so profit is measured as $100.

Constant purchasing power

Inflation over time makes comparisons difficult so constant purchasing power adjusts for
general indices of inflation – e.g. retail prices index (RPI).
 If increase in RPI is 5%
 Increase opening capital by 5% ×1000 = $1,050
 So profit is only $1,100 – $1,050 = $50.

0321-2676000 Ali Amanullah aliamanullahacca@[Link]