THE IFRS FRAMEWORK

1 Business Context

The way that items and transactions are treated and presented in the financial statements may affect an investor’s perception of the position and performance of an entity. In addition, it may directly affect the way in which contracts based on accounting numbers are written and the size of an entity’s tax liability. There is therefore a real danger that the accounting standards setting process may be politically influenced or dominated by self-interest groups. To ensure that this threat does not become a reality, it is important that there is a framework that sets out the wider purposes that accounting standards are intended to achieve and the principles to guide the development of detailed requirements, thereby achieving consistent standards. The IASB’s Framework for the preparation and presentation of financial

Statements attempts to do this in the context of IFRS. It sets out consistent principles which form the basis for the development of detailed requirements in IFRS.

2 Chapter Objectives

This chapter explains the standard setting process, and the concepts underpinning the development of IFRS. In particular, it looks at:

 the International Financial Reporting Standard setting process;

 the Preface to International Financial Reporting Standards (the Preface); and

 the Framework for the preparation and presentation of financial statements (the Framework).

On completion of this chapter you should be able to:

 understand the purpose and role of accounting standards;

 understand the standard-setting process applied by the IASB;

 explain:

o the purposes of financial reporting; and

o how financial reporting can assist the management of an entity in being accountable to the entity’s shareholders and other stakeholders;

 understand the qualitative characteristics of financial information set out in the Framework and the constraints on them; and

 understand the elements of financial statements set out in the Framework.

3 The Purpose of Accounting Standards

The overall purpose of accounting standards is to identify proper accounting practices for the preparation of financial statements.

Accounting standards create a common understanding between users and preparers on how particular items, for example the valuation of property, are treated. Financial statements should therefore comply with all applicable accounting standards.

4 The Role of Accounting Standards

The content of financial statements is often defined by national laws prescribing what, how, and when disclosures should be made. Such requirements, however, are often high-level with little, if any, detailed guidance on how the requirements should be implemented in practice. The role of accounting standards is therefore to translate high-level principles into reasoned procedures that an entity can apply in practice. Accounting standards may be based either on what is commonly referred to as the ‘rules based approach’ or the ‘principles-based approach’. A rules-based approach is exactly as its name suggests detailed rules on a subject. The rules are developed to cover every possible eventuality. If an item or transaction is not covered by a detailed rule, discretion is granted as to how to account for it in the financial statements. This leads in practice to long and often convoluted standards and can encourage a process best described as ‘loop holing’, where preparers of financial statements attempt to find loopholes in the rules which enable them to ignore the accounting requirements. The standard setters as a result are forced to issue more rules to plug the loophole, and so on. The US standard setting body, the Financial Accounting Standards Board (FASB) has historically issued standards using the rules-based approach. A principles-based approach involves explaining the general principles that an accounting standard is based on and then providing practical guidance and explanation on how an entity might meet those principles. While containing many detailed rules, IFRS are set on a principles-based approach.

Illustration 1

IAS 17 Leases sets out the general principle that: “A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership.” The standard goes on to describe what the risks and rewards of ownership might be. However, by setting out the general principle first, entities are required to look at the overall substance of a lease transaction and not see whether they can structure a lease that does not fit into one of the specified criteria. In comparison, the US standard on leasing, Statement of Financial Accounting Standards (SFAS) No. 13 Accounting for leases uses the rules-based approach. It sets out that a lease should be classified as a finance lease (US terminology for a finance lease is a ‘capital lease’) if it meets any one of a list of four criteria. If the lease does not meet one of the specified four criteria, then it should be classified as an operating lease.

Thus whilst a rules-based approach may seem tougher, it could be argued that a principles based approach leads to more compliance with the overall intention of the standards setters when they wrote the standard.

5 International and National Accounting Standards

An entity is normally required to comply with the accounting requirements for the country in which it is registered. However, many entities are large multinational groups and they may list their shares on a number of stock exchanges around the world. Where accounting requirements are different in each country in which an entity is listed, the entity may be required to prepare its financial statements on a number of different bases. In practice, an entity will generally prepare its financial statements using the requirements for the country in which it is registered, but include a list of differences that arise as a result of applying a different set of national standards. As discussed in Chapter 1, the requirement for a reconciliation to be presented by US registrants between amounts in financial statements prepared under IFRS and amounts in those prepared under US generally accepted accounting practice (GAAP) has now been removed. Pressure continues for the adoption of a single set of global accounting standards. Indeed the use of IFRS is already widespread and the number of different sets of accounting standards being used is reducing.

6 Setting International Financial Reporting Standards

6.1 The IASCF

The International Accounting Standards Committee Foundation (IASCF) was formed in March 2001 as a not-for-profit corporation and is the parent entity of the IASB. The IASCF is an independent organization and its trustees exercise oversight and raise necessary funding for the IASB to carry out its role as standard setter.

6.2 Membership

Membership of the IASCF has been designed so that it represents an international group of preparers and users, who become IASCF Trustees. The selection process for the 22 trustees takes into account geographical factors and professional background. The IASCF trustees appoint the IASB members.

6.3 The standard-setting process

The IASB process for developing new standards is set out in the Preface and generally involves the following stages (those marked in italics are always required): [Preface 18]

 Staff review the issues associated with the topic, including the application of the

Framework, and carry out a study of national requirements and practices in relation to an issue;

 Exchange views with national standards setters (to establish how acceptable the standard would be in national jurisdictions);

 Consultation with the Standards Advisory Council (SAC) on whether the issue should

be added to the IASB’s agenda. The SAC is made up of organizations and individuals with an interest in international financial reporting;

 the formation of an advisory group with specialist interest and knowledge in the topic;

 issue of a discussion paper for public comment;

 the publication of an exposure draft, together with any dissenting opinions held by IASB members and a basis of conclusions. Its content should be approved by at least nine of the fourteen IASB members;

 the publication of a basis of conclusion with exposure drafts;

 consideration of all comments received on an exposure draft during the comment period;

 public hearings about, and field tests of, the exposure draft;

 issue of a standard together with any dissenting opinions held by IASB members. Its content is required to be approved by at least nine of the fourteen members; and

 the publication of the standard should include a basis of conclusions and a description of the due process undertaken.

Written contributions are welcomed at all stages in this process. The IASB has a public gallery at its monthly meetings (and observers can log-on to a live web cast of the meetings) which allows interested parties to attend as observers.

The predecessor body to the IASB, the International Accounting Standards Committee (IASC) issued IAS numbers 1 – 41 (although there are gaps in the sequence with some standards being subsequently superseded or withdrawn). The IASB adopted all previously issued standards. Standards issued by the new IASB can be identified as they are prefixed with IFRS rather than IAS.

6.4 Prefaces to International Financial Reporting Standards

The Preface sets out the objectives and due process of the IASB. It also explains the scope, authority and timing of the application of IFRS

The Preface highlights a number of other important matters:

 that IFRS apply to all general purpose financial statements of all profit oriented entities and are directed to the common information needs of a wide range of users;

 the IASB’s objective is to require like transactions and events to be accounted for in a like way and not to permit choices. It recognises that the IASC permitted different treatments for given transactions and events (‘benchmark treatment’ and ‘allowed alternative treatment’) and has the objective to reduce choice; [Preface 12, 13] and

 Standards include paragraphs in bold and plain type. Bold type paragraphs indicate the main principles. However, both types have equal authority [Preface 14].

7 The Context for Financial Reporting

This section examines the context for financial reporting, including its purpose, the needs of users of financial statements and how these are met, and the key principles underlying financial statements. The main areas addressed are outlined in the following diagram:

8 What is Financial Reporting?

8.1 Definition

‘Financial reporting’ is the provision of financial information about an entity to external users, that is useful to them in making economic decisions and for assessing the effectiveness of the entity’s management. Typically, this information is made available annually, half-yearly or quarterly and is presented in formats laid down or approved by the governments and other regulators in each national jurisdiction.

8.2 Financial statements

The principal way of providing financial information to external users is through the annual financial statements. Financial statements are the summary of the performance of an entity over a particular period and its financial position at the end of that period. Financial statements are designed to meet the common needs of a wide range of users, and therefore are not tailored to the needs of any particular user group. Financial statements comprise four primary statements and the accompanying notes, as set out in IAS 1 Presentation of financial statements.

9 The Framework for the Preparation and Presentation of Financial Statements

The Framework sets out the concepts that underlie the preparation and presentation of financial statements. Such concepts are the foundation on which financial statements are constructed and provide a platform from which standards are developed. The Framework is important because it [Framework 1]:

 assists the IASB in the development of new standards and the revision of existing standards;

 provides a rationale for reducing the number of alternative accounting treatments and promoting harmonization of accounting standards and regulations;

 assists national standard setters in developing their national standards on a basis consistent with international principles;

 assists preparers of financial statements in applying IFRS and general principles;

 assists auditors in forming an opinion on whether financial statements conform with IFRS;

 assists users of financial statements in their interpretation of financial statements; and

 provides information on the work carried out by the IASB.

The Framework is not an accounting standard and it does not contain detailed requirements on how financial statements should be prepared or presented. Specific references to the Framework can be found, however, in individual accounting standards dealt with in later chapters.

9.1 Users and their information needs

9.1.1 Economic decisions

The content and presentation of financial statements are influenced by the use to which the financial statements are to be put, for example:

 an investor deciding when to buy, hold, or sell shares;

 employees assessing an entity’s ability to provide benefits to them;

 investors assessing an entity’s ability to pay dividends and therefore the likely return that they will achieve on their investment; and

 debt providers assessing the level of security for amounts lent to the entity.

9.1.2 Users and specific needs

The Framework identifies users of financial statements and their specific information needs as set out in the illustration below. [Framework 9]

Illustration 2

Users of financial information and why the information is of interest to them:

1. Investors

Investors require information on risk and return on investment and hence an entity’s ability to pay dividends.

2. Employees

Employees assess an entity’s stability and profitability. They are interested in their employer's ability to provide remuneration, employment opportunities and retirement and other benefits.

3. Lenders

Lenders assess whether an entity is able to repay loans and its ability to pay the related interest when it falls due.

4. Suppliers and other trade payables

Suppliers assess the likelihood of an entity being able to pay them as amounts fall due.

5. Customers

Customers assess whether an entity will continue in existence. This is especially important Where customers have a long-term involvement with, or are dependent on, an entity, for example where product warranties exist or where specialist parts may be needed.

6. Governments and their agencies

Government bodies assess the general allocation of resources and therefore activities of entities. In addition information is needed to determine future taxation policy and to provide national statistics.

7. The public

The financial statements provide the public with information on trends and recent developments. This may be of particular importance where an entity makes a substantial contribution to a local economy by providing employment and using local suppliers.

9.2 Accountability of management

Management is accountable for the safekeeping of the entity’s resources and for their proper, efficient and profitable use. Shareholders are interested in information that helps them to assess how effectively management has fulfilled this role, as this is relevant to the decisions concerning their investment and the reappointment or replacement of management. Financial reporting helps management to meet its need to be accountable to shareholders and also to other stakeholders such as employees or lenders, by providing information that is useful to the users in making economic decisions.

9.3 Financial position, performance and changes in financial position

All economic decisions should be based on an evaluation of an entity’s ability to generate cash and the timing and certainty of its generation. Information about the entity’s financial position, performance and changes in its financial position provides information to support such decisions. [Framework 12]

Information about an entity’s financial position is provided in a statement of financial position, previously known as a balance sheet, as outlined in Chapter 3.

Profit is used as the measure of financial performance. Information on an entity’s financial performance is provided by the statement of comprehensive income, previously known as the income statement.

Cash flow information provides an assessment of changes in an entity’s financial position and is largely free from the more judgmental issues that arise when items are included in the statement of financial position or statement of comprehensive income.

9.4 Underlying assumptions

There are two fundamentally important assumptions on which financial statements are based, being the accrual basis of accounting and the going concern basis. Both of these are discussed in IAS 1. However, the fundamental principle of the accrual basis of accounting is that transactions are recorded in the financial statements when they occur, not when the related cash flows into or out of the entity occur. [Framework 22] Under the going concern basis, financial statements are prepared on the assumption that an entity will continue in operation for the foreseeable future. This basis is important, for example, in the assessment of the recoverability of a non-current asset, which is expected to

generate benefits in the ongoing business even if its resale value is minimal. [Framework 23]

9.5 Qualitative characteristics of financial statements

In deciding which information to include in financial statements, when to include it and how to present it, the aim is to ensure that the information is useful to users of the financial statements in making economic decisions. The attributes that make information useful are known as qualitative characteristics and are described in terms of understandability, relevance, reliability and comparability in the context of the preparation of financial statements. [Framework 24]

9.5.1 Understandability

Information in financial statements should be understandable to users. This will, in part,

depend on the way in which information is presented.

Financial statements cannot realistically be understandable to everyone, and therefore it is assumed that users have:

 a reasonable knowledge of business and accounting; and

 a willingness to study with reasonable diligence the information provided.

9.5.2 Relevance

Information is relevant if it has the ability to influence the economic decisions of users and is provided in time to influence those decisions. Relevance has two characteristics: a predictive value and a confirmatory value. Users can make a reasoned evaluation of how management might react to certain future events, whilst information about past events will help them to confirm or adjust their previous assessments. Information about an entity’s financial position and past performance is often used as the

basis for making predictions about its future performance. It is therefore important how information is presented. For example, unusual and infrequent items of income and expense should be disclosed separately.

9.5.3 Reliability

Information may be relevant, but unless it is reliable as well it is of little use. Information is considered to be reliable if it does not contain substantial errors that would affect the economic decisions of users and if it represents faithfully the entity’s transactions.

Faithful representation requires that transactions are accounted for, and presented in accordance with, their substance and economic reality, even where this is different from their legal form. Management should present information which is neutral, i.e. free from bias. To be reliable, information should also be complete.

9.5.4 Comparability

For financial information to be useful, it is important that it can be compared with similar information of previous periods or to that produced by another entity. For information to be comparable it should be consistently prepared; this can be achieved by an entity adopting the same accounting policies from one period to the next as explained in IAS 8 Accounting policies, changes in accounting estimates and errors.

9.6 Elements of financial statements

The elements included in the financial statements are the building blocks from which financial statements are constructed. These elements are broad classes of events or transactions that are grouped according to their economic characteristics. [Framework 47]

9.6.1. Definitions of elements

Examples of elements of financial statements:

Elements Definition Comment Examples

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 An asset may be utilized in a business in a number of ways, but all will lead to the generation of future economic benefits (i.e. a contribution to cash flowing to the entity). Cash, inventories, receivables, prepayments, plant, property and equipment.

Liability A present obligation of the entity “arising from past events, the settlement of which is expected to result in an outflow” of an entity’s resources

A liability exists where an entity has a present obligation. An obligation is simply a duty or responsibility to perform in a certain way. It is important to make a clear distinction between a present obligation and a future commitment. Trade payables, unpaid taxes and outstanding loans.

Equity The residual interest in an entity’s assets after deducting all its Liabilities Equity = ownership interest = net assets (i.e. share capital and reserves) Share capital, retained earnings, revaluation reserve and other reserves.

Income Increases in economic benefits not resulting from contributions made by equity holders Income comprises both revenue and gains. Revenue arises from an entity’s normal operating activities.

Gains are increases in economic benefits as is revenue and therefore are not separately identified within the Framework. Revenue, revaluations, profit on the sale of a non-current asset and interest received on investments.

Expenses Decreases in economic benefits not resulting from distributions to equity holders Expenses include losses, for example write-downs of non-current assets. Material and labor costs, depreciation, interest paid on loans and a write-down of an asset.

9.6.2 Recognition of elements in financial statements

An item is classed as 'recognized' when it is included in the financial statements. [Framework 82] An item should be recognized if it is probable that there will be an inflow or outflow of economic benefits associated with the asset or liability, and the asset or liability can be measured reliably. [Framework 83] The assessment of the outcome of an event as being probable is linked with the uncertainty of the business environment in which an entity operates. There is no precise point that can be identified at which an event is assessed as being probable. An entity is instead required to make an assessment based on the facts at the time of the preparation of the financial statements. An item to be recognized in the financial statements needs to be capable of reliable measurement; however, this does not mean that the amount must be certain, as the use of estimates is permitted.

Revenue should be earned before it is recognized in the statement of comprehensive income. Revenue is earned as increases in assets and decreases in liabilities are recognized from an entity’s activities.

Expenses are recognized when there is a decrease in an asset or an increase in a liability. Matching is a useful concept that encourages the review of all the aspects of a transaction, as it considers whether an asset arises when a liability is recognized and vice versa. It is a concept that matches expenses with income.

9.6.3 Measurement in financial statements

For an item or transaction to be recognized in an entity’s financial statements it needs to be

measured at a monetary amount. There are several different measurement bases which can

be used to recognized items in the financial statements. The measurement bases referred to in the Framework and commonly used in IFRS are: [Framework 99, 100]

 historical cost. Assets are recorded at their original cost. Liabilities are recorded at their original amount received or the cash expected to be paid out to settle them;

 current cost. Assets are recorded at the amount that would have to be paid out at the end of the reporting period for an equivalent asset. Liabilities are recorded at the value that they could be settled for at the end of the reporting period;

 realisable or settlement value. Assets are recorded at the amount that they could be sold for now and similarly liabilities are recorded at the amount expected to be paid out; and

 present value. This measurement basis involves discounting future cash flows to take account of the time value of money.

Although the Framework includes an explanation of the different measurement options, IFRS are primarily based on historical cost.

10 Chapter Review

This chapter has been concerned with the process by which IFRS are set, thus providing useful background information for understanding the purpose and role of accounting standards.

The Framework is an essential element to understanding the chapters in this manual. It deals with the purposes and role of financial reporting. In summary, this chapter has covered:

 The International Financial Reporting Standard setting process;

 The content of the Preface to international financial reporting standards; and

 The content of the Framework for the preparation and presentation of financial statements in particular looking at:

o the information needs of different users of financial statements;

o the qualitative characteristics of financial information;

o the elements of financial statements; and

o recognition criteria of the elements in financial statements.