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Financial Reporting Brief

August 2018

This month’s article 'Financial Reporting – Understanding the Concepts' looks at the revised Conceptual Framework published earlier this year and some of the main revisions made.

Monthly Article - August 2018

Financial Reporting – Understanding the Concepts

Two major authoritative documents which first saw the light well more than 20 years ago have been subject to major revival in recent times. They are the UK Corporate Governance Code, first published in 1991 by the Financial Reporting Council, and the Conceptual Framework for Financial Reporting, first published in 1989 by the International Accounting Standards Board. 

While the documents differ in many aspects as to their intent, they also share many common objectives, with perhaps one of the most significant being the building and reinvigorating of trust in the reporting of company performance. 

In this month’s article the focus is on the Conceptual Framework, while next month we shall turn to Corporate Governance.

Conceptual Framework – Purpose

The Framework is not a Standard and does not override any specific IFRS. The framework’s purpose is to assist the IASB in developing and revising IFRSs that are based on consistent concepts, to help preparers develop consistent accounting policies for areas that are not covered by a Standard or where there is choice of accounting policy, and to assist all parties to understand and interpret IFRS.  In the absence of a Standard or an Interpretation that specifically relates to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IFRS requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income and expenses in the framework.

Key Concepts Revived

It is notable that the Conceptual Framework reintroduces in its revised version the terms of ‘stewardship’ and ‘prudence’ which appeared to many people as if they were downgraded along the way at various draft stages. The IASB strengthens its position in relation to stewardship, stating that users need information to help them assess management’s stewardship so that they can hold management to account for resources entrusted to their care. The assessment helps users to make decisions about providing resources to the entity, which is the objective of general purpose financial reporting. 

The IASB has reintroduced explicit reference to prudence, which is the exercise of caution when making judgements under conditions of uncertainty.  Prudence is in support of neutrality – ‘depiction without bias’, insofar as it is with the intent of avoiding bias towards recognising fewer assets and more liabilities – assets and liabilities should be neither overstated nor understated. The rationale for the IASB’s views on neutrality and prudence is that a systemic bias towards conservatism undermines the value of earnings as a performance indicator.

Recognition and Measurement 

Measurement uncertainty affects whether an item is recognised and the selection of an appropriate measurement basis for it, and the Framework discusses at length such aspects as measurement, recognition and derecognition.  The Framework emphasises that estimates are an essential part of financial reporting and they do not undermine the usefulness of the reported information if the estimates are properly determined and the uncertainties disclosed. 

Assets and Liabilities – What are they? 

The definitions of an asset and a liability have been refined and the definitions of income and expenses have been updated to reflect that refinement. The revised definition of an asset is – ‘A present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits’. The revised definition of a liability is – ‘A present obligation of the entity to transfer an economic resource as a result of past events. An obligation is a duty or responsibility that the entity has no practical ability to avoid’. 

The new asset definition focuses on rights and removes reference to the flow of economic benefits – this lowers the hurdle for identifying the existence of an asset and puts more emphasis on reflecting uncertainty in measurement. The recognition of assets as rights, or a set of rights, is consistent with the IASB’s recent decisions on recognising a right-of-use asset in IFRS 16 ‘Leases’.   Control links a right to an entity and conceptually this is similar to IFRS 10 ‘Consolidated Financial Statements’ and IFRS 15 ‘Revenue from Contracts’.   Control encompasses both power, as to how the resource is used, and the benefits from that resource. 

The revised Conceptual Framework discusses how the ‘no practical ability to avoid’ criterion is applied to liabilities in the following circumstances:

  • If a duty or responsibility arises from the entity’s customary practices, published policies or specific statements – the entity has an obligation, if it has no practical ability to act in a manner inconsistent with those practices, policies or statements.
  • If a duty or responsibility is conditional on a particular future action that the entity itself may take – the entity has an obligation, if it has no practical ability to avoid taking that action. 

The revised Conceptual Framework clarifies the definition of a liability that it is an obligation to transfer the economic resource, not the ultimate outflow of economic benefits. It clarifies further that if new legislation is enacted, a present obligation arises only when an entity obtains economic benefits, or takes an action, within the scope of the legislation. The enactment of legislation is not in itself sufficient to give an entity a present obligation. 

Conclusion

The Deloitte publication ‘IFRS in Focus: Revised Conceptual Framework’ outlines the main changes and the key concepts in the revised Framework. 

Some standards include specific references to the Framework and these have been updated with consequential amendments to the affected standards so that they refer to the new Framework. 

Other developments which will have a pervasive impact on financial statements include the Disclosure Initiative and the IASB project on primary financial statements to make targeted improvements to the structure and content of the primary financial statements. 

The Conceptual Framework is a fundamental document underlying the understanding of reporting standards and principles to be considered when making decisions on accounting policies and related judgements.

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