International GAAP® 2015 The global perspective on IFRS

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International GAAP® 2015Generally Accepted Accounting Practice under International Financial Reporting StandardsEY9781118999981 • over 4000 pages • Dec 2014 • £140.00 / €168.00 / $225.00

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Chapter 2 The IASB’s Conceptual Framework

 

1  INTRODUCTION .................................................................................................... 37 1.1  What is a conceptual framework? .................................................................. 38 1.2 Why is a conceptual framework necessary? .................................................. 38

2  THE IASB’S CONCEPTUAL FRAMEWORK .............................................................. 40 2.1  Development of the IASB’s Conceptual Framework ................................... 40 2.2 Contents, purpose and scope of the IASB’s Conceptual Framework ......... 41

2.2.1  Contents of the Conceptual Framework ........................................ 41 2.2.2 Purpose and scope of the Conceptual Framework ........................ 41

2.2.2.A  Purpose ............................................................................. 41 2.2.2.B Scope ................................................................................ 42

2.3  Chapter 1: The objective of general purpose financial reporting ............... 42 2.3.1  Objective, usefulness and limitations of general purpose

financial reporting ........................................................................... 43 2.3.1.A  Objective and usefulness ................................................. 43 2.3.1.B Limitations ....................................................................... 44

2.3.2  Information about economic resources, claims and changes in resources and claims .................................................................... 45

2.3.2.A  Economic resources and claims ....................................... 45 2.3.2.B Changes in economic resources and claims .................... 45

2.4  Chapter 2: The reporting entity ................................................................... 46 2.5 Chapter 3: Qualitative characteristics of useful financial

information ..................................................................................................... 48 2.5.1  Fundamental qualitative characteristics ........................................ 49

2.5.1.A  Relevance (including materiality) ................................... 49 2.5.1.B Faithful representation .................................................... 49 2.5.1.C Applying the fundamental qualitative

characteristics ................................................................... 51 2.5.2  Enhancing qualitative characteristics ............................................. 52

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2.5.2.A  Comparability ................................................................... 52 2.5.2.B Verifiability ....................................................................... 52 2.5.2.C Timeliness ........................................................................ 53 2.5.2.D Understandability ............................................................ 53 2.5.2.E Applying the enhancing qualitative

characteristics ................................................................... 53 2.5.3  The cost constraint ......................................................................... 53

2.6  Chapter 4: The Framework (1989): the remaining text ............................. 54 2.6.1  Underlying assumption (going concern) ........................................ 54

2.6.1.A  Possible future developments ......................................... 54 2.6.2  The elements of financial statements ............................................ 55

2.6.2.A  Statement of financial position ....................................... 55 2.6.2.B Assets ................................................................................ 56 2.6.2.C Liabilities ......................................................................... 57 2.6.2.D Equity ............................................................................... 59 2.6.2.E Performance ..................................................................... 60 2.6.2.F Income .............................................................................. 61 2.6.2.G Expenses ........................................................................... 62 2.6.2.H Realisation ........................................................................ 62 2.6.2.I Transactions with owners acting in another

capacity ............................................................................. 62 2.6.2.J Capital maintenance adjustments ................................... 63

2.6.3  Recognition of the elements of financial statements .................... 63 2.6.3.A  Probability of future economic benefit or outflow ......... 63 2.6.3.B Reliability of measurement ............................................. 64 2.6.3.C Recognition of assets ....................................................... 64 2.6.3.D Recognition of liabilities .................................................. 64 2.6.3.E Recognition of income ..................................................... 64 2.6.3.F Recognition of expenses .................................................. 65 2.6.3.G Possible future developments ......................................... 65

2.6.4  Measurement of the elements of financial statements ................. 66 2.6.4.A  Possible future developments ......................................... 67

2.6.5  Concepts of capital and capital maintenance ................................ 67 2.6.5.A  Financial capital maintenance ......................................... 68 2.6.5.B Physical capital maintenance .......................................... 69 2.6.5.C Possible future developments ......................................... 69

2.7  Management commentary ............................................................................. 69

3  POSSIBLE FUTURE DEVELOPMENTS ..................................................................... 70 3.1  Presentation and disclosure .......................................................................... 70 3.2 Role of the business model in determining an accounting treatment ........ 70

4  CONCLUSION ........................................................................................................ 71

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Chapter 2 The IASB’s Conceptual Framework

 

1 INTRODUCTION There have been numerous attempts over many decades to define the purpose and nature of accounting. Perhaps not surprisingly, most of the earlier studies were carried out by individual academics and academic committees in the US; for example, the writings in 1940 of Paton and Littleton1 were intended to present a framework of accounting theory that would be regarded as a coherent and consistent foundation for the development of accounting standards, whilst the studies carried out over the years by various committees of the American Accounting Association have made a significant contribution to accounting theory.2 In addition to the research carried out by individuals and academic committees, professional accounting bodies around the world have also, from time to time, issued statements that deal with various aspects of accounting theory. These can be seen as the first attempts at developing some form of conceptual framework.

With the globalisation of business and the increased access to the world’s capital markets that goes with it, there are essentially only two truly global systems of financial reporting – IFRS and US GAAP.

In 2004 the IASB and FASB began a joint project to develop a single conceptual framework, the first phase of which was completed in September 2010. The IASB’s current conceptual framework, discussed more fully at 2 below, comprises two sections finalised in this first phase of the joint project with the FASB, together with other material carried forward from the conceptual framework issued by the former IASC in 1989 (‘the 1989 Framework’), which was originally intended to be replaced in a second phase of the joint framework project. The 1989 Framework, although not jointly developed with the FASB, nevertheless drew heavily on the FASB’s then current conceptual framework. This close direct and indirect relationship between the IASB’s and FASB’s frameworks goes some way to explain the progress that the two Boards have made towards convergence at the individual standard level.

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Following the completion of the first phase in 2010, the joint project with the FASB stalled somewhat until, in 2012, the IASB indicated that it no longer saw convergence between IFRS and US GAAP in the area of the conceptual framework as a primary objective and, moreover, that active work on the conceptual framework would resume shortly. This resulted in the publication by the IASB in July 2013 of a discussion paper DP/2013/1 – A Review of the Conceptual Framework for Financial Reporting. The IASB intends to publish an exposure draft of an updated framework in the first quarter of 2015. The discussion paper notes that this is no longer a joint project with the FASB, but the IASB’s own project.3 The key proposals of the discussion paper are noted at relevant places in the commentary below.

1.1 What is a conceptual framework? In general terms, a conceptual framework is a statement of generally accepted theoretical principles which form the frame of reference for a particular field of enquiry. In terms of financial reporting, these theoretical principles provide the basis for both the development of new reporting practices and the evaluation of existing ones. Since the financial reporting process is concerned with the provision of information that is useful in making business and economic decisions, a conceptual framework will form the theoretical basis for determining which events should be accounted for, how they should be measured and how they should be communicated. Therefore, although it is theoretical in nature, a conceptual framework for financial reporting has a highly practical end in view.

1.2 Why is a conceptual framework necessary? A conceptual framework for financial reporting should be a theory of accounting against which practical problems can be tested objectively, and the utility of which is decided by the adequacy of the practical solutions it provides. However, the various standard-setting bodies around the world initially often attempted to resolve practical accounting and reporting problems through the development of accounting standards, without such an accepted theoretical frame of reference. The end result was that standard-setters determined the form and content of external financial reports, without resolving such fundamental issues as: • What are the objectives of these reports? • Who are the users of these reports? • What are the informational needs of these users? • What types of report will best satisfy their needs?

Consequently, standards were often produced on a haphazard and ‘fire-fighting’ basis with the danger of mutual inconsistencies. By contrast, an agreed framework would, in principle, provide standard-setters with a basis for designing standards that facilitate more consistent external financial reports that meet the needs of the user.

Whilst the main role of a conceptual framework may be to assist the standard-setter (the focus of the discussion in the remainder of this section), the IASB sees its own framework as a point of reference not only for itself, but also for other (national) standard-setters, preparers, auditors and users (see 2.2.2.A below).

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It is key that any framework is ‘agreed’. The IASB’s original 1989 Framework was clearly derived from the FASB framework, which had been developed much earlier. However, the way in which the two Boards then translated the common principles of their frameworks into detailed rules within the accounting standards issued by each Board can result in very different accounting treatments.

Experience of the last thirty years also shows that, in the absence of an agreed comprehensive conceptual framework, the same theoretical issues were revisited on numerous occasions by different standard-setting bodies. This inevitably sometimes resulted in the development of standards that were internally inconsistent and inconsistent with each other, or which were founded on incompatible concepts. For example, inconsistencies and conflicts have existed between and within individual standards concerning the emphasis placed on substance versus form; neutrality versus prudence; and whether earnings should be determined through balance sheet measurements or by matching costs and revenue. Some standard-setters have permitted two or more methods of accounting for the same set of circumstances, whilst others permitted certain accounting practices to be followed on an arbitrary or unspecified basis. These inconsistencies and irrationalities perhaps reflect the fundamental difficulty of determining what is required in order to give a faithful representation of economic phenomena.

Standard setters have adopted different approaches to the realisation of their conceptual frameworks in specific accounting standards. This can be seen by comparing the standards issued by the FASB with those issued by the IASB. In the US the FASB, in spite of its pioneering work on a conceptual framework, has produced a large number of highly detailed accounting rules. The IASB, on the other hand has tended to produce less detailed standards, relying on preparers and auditors to consider the general principles on which they are based in applying them to specific situations. Clearly, the proliferation of accounting standards in the US stems from many factors, not least the legal and regulatory environment. However, a more satisfactory conceptual framework might reduce the need for such a large number of highly detailed standards, since the emphasis would be on general principles rather than specific rules. Indeed this change of emphasis has been specifically considered by the US authorities following the financial reporting problems that led, in the US, to the Sarbanes-Oxley Act and the establishment of the Public Company Accounting Oversight Board. This is not to say that the IASB’s more general ‘principles-based’ approach to standard setting is necessarily more satisfactory than the FASB’s; rather, the legal and regulatory environment within which non-US businesses habitually work is quite different from that of the USA.

The political and economic environment influences not only the approach taken to standard setting, but also the nature of the conceptual framework on which standards are based. Following the widespread incorporation of IFRS into the national GAAPs of many other countries, the IASB is faced with many stakeholders with a variety of needs and expectations. These different stakeholders often express differing views on proposals issued by the IASB and expect their views to be taken into account. Under these circumstances, an agreed conceptual framework is of great value, although the best defence against undue interference in the standard-setting

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process is the need of the capital markets for financial reporting that provides a sound basis for decision making, which in turn implies a system of financial reporting characterised by relevance, faithful representation, practicality and understandability. While it is probable that these characteristics are more likely to be achieved using a sound theoretical foundation, the converse also applies: namely that the framework must result in standards that account appropriately for actual business practice and economic reality. Otherwise how, for example, is an industry to be persuaded that a particular accounting treatment perceived as adversely affecting its economic interests is better than one which does not?

An agreed framework is therefore not the panacea for all accounting problems. Nor does it obviate the need for judgement to be exercised in the process of resolving accounting issues. What it can provide is a framework within which those judgements can be made. Indeed this is happening, as the principles expressed in the IASB’s framework are frequently referred to in IFRSs and during the process of their development. Unfortunately there is also evidence of the IASB issuing standards that contravene its own conceptual framework. For example IAS 38 – Intangible Assets – requires the capitalisation of goodwill as an asset, despite the fact that goodwill does not meet the definition of an asset in the IASB’s framework. Similarly IAS 12 – Income Taxes – requires recognition of deferred tax assets and liabilities that arguably do not meet the definitions of asset and liability under the framework.

2 THE IASB’S CONCEPTUAL FRAMEWORK

2.1 Development of the IASB’s Conceptual Framework The IASB issued Conceptual Framework for Financial Reporting 2010 (‘the Conceptual Framework’) in September 2010. This was effectively work-in-progress, comprising two chapters developed in the first phase of the then joint project of the IASB and FASB to develop an agreed framework (see 1 above), together with material carried forward from the former IASC’s 1989 Framework (which was adopted in 2001 by the then newly-constituted IASB).

In the discussion paper on the Conceptual Framework published in July 2013 (see 1 above), the IASB acknowledges that some have criticised various aspects of the two chapters issued in September 2010 as being inferior to those sections of the IASC’s Framework which they replaced. In particular, the current framework: • does not specifically refer to ‘stewardship’ (see 2.3.1.A below); • uses the term ‘faithful representation’ rather than ‘reliability’ (see 2.5.1.B below);

and • emphasises neutrality rather than prudence (see 2.5.1.B below).

The IASB has indicated that it does not propose to make any fundamental changes to the existing chapters of the Conceptual Framework, except where its work on other chapters highlights areas in need of clarification or amendment.4

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2.2 Contents, purpose and scope of the IASB’s Conceptual Framework

2.2.1 Contents of the Conceptual Framework The Conceptual Framework comprises an introduction (discussed here and at 2.2.2 and 2.3.1 below), and four chapters: • Chapter 1 – The objective of general purpose financial reporting (discussed

at 2.3 below); • Chapter 2 – The reporting entity. This is a ‘space-holder’ chapter pending

completion of this phase of the IASB’s framework (discussed at 2.4 below); • Chapter 3 – Qualitative characteristics of useful financial information

(discussed at 2.5 below); • Chapter 4 – The Framework (1989): the remaining text (discussed at 2.6

below), comprising • Underlying assumption (discussed at 2.6.1 below); • The elements of financial statements (discussed at 2.6.2 below); • Recognition of the elements of financial statements (discussed at 2.6.3

below); • Measurement of the elements of financial statements (discussed at 2.6.4

below); and • Concepts of capital and capital maintenance (discussed at 2.6.5 below).

2.2.2 Purpose and scope of the Conceptual Framework

2.2.2.A Purpose The purpose of the Conceptual Framework is to: • assist the Board in the development of future IFRSs and in its review of

existing IFRSs; • assist the Board in promoting harmonisation of regulations, accounting

standards and procedures relating to the presentation of financial statements by providing a basis for reducing the number of alternative accounting treatments permitted by IFRSs;

• assist national standard-setting bodies in developing national standards; • assist preparers of financial statements in applying IFRSs and in dealing with

topics that have yet to form the subject of an IFRS; • assist auditors in forming an opinion on whether financial statements comply

with IFRSs; • assist users of financial statements in interpreting the information contained in

financial statements prepared in compliance with IFRSs; and • provide those who are interested in the work of the IASB with information

about its approach to the formulation of IFRSs. [CF Purpose and status].

The Conceptual Framework is not an IFRS, and nothing in it overrides any specific IFRS, including an IFRS that is in some respect in conflict with the framework. As the

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Board will be guided by the framework both in developing future standards, and in reviewing existing ones, the number of such conflicts is expected to reduce over time [CF Purpose and status]. However, any revision of the framework (such as that proposed in the IASB’s recent discussion paper – see 1 above) might actually increase such conflicts, at least in the shorter term. Nevertheless, the Conceptual Framework is a source of guidance for determining an accounting treatment where a standard does not provide specific guidance (see Chapter 3 at 4.3).

The framework will be revised from time to time in the light of the IASB’s experience of working with it. [CF Purpose and status].

The IASB’s recent discussion paper (see 1 above) expresses some concern that the above list of potential users in the current framework is too long, and that the primary focus of any revised framework should be to assist the IASB in identifying concepts to be used for developing and revising IFRSs. The discussion paper acknowledges that the revised framework should be available to others to assist in interpreting a standard or developing an accounting treatment for a transaction not covered by a standard. Interestingly, however, the discussion paper suggests that, although the revised framework will be generally available for use by third parties in this way, other parts of the framework may be explicitly ‘ear-marked’ as for the IASB’s use only.5

2.2.2.B Scope The Conceptual Framework deals with: • the objective of financial reporting; • the qualitative characteristics of useful financial information; • the definition, recognition and measurement of the elements from which

financial statements are constructed; and • concepts of capital and capital maintenance. [CF Scope].

2.3 Chapter 1: The objective of general purpose financial reporting Chapter 1 of the Conceptual Framework discusses the objective of general purpose financial reporting, which – in the IASB’s view – forms the foundation of the framework. Other aspects of the framework (a reporting entity concept, the qualitative characteristics of, and the constraint on, useful financial information, elements of financial statements, recognition, measurement, presentation and disclosure) flow logically from the objective. [CF.OB1].

The Chapter is divided into two main sections dealing with: • the objective, usefulness and limitations of general purpose financial reporting

(see 2.3.1 below); and • information about a reporting entity’s economic resources, claims, and changes

in resources and claims (see 2.3.2 below).

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2.3.1 Objective, usefulness and limitations of general purpose financial reporting

2.3.1.A Objective and usefulness The Conceptual Framework defines the objective of general purpose financial reporting as being: ‘to provide financial information about the reporting entity that is useful to

existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit.’ [CF.OB2].

Existing and potential investors, lenders and other creditors (collectively, ‘providers of capital’) cannot generally require reporting entities to provide information directly to them and must rely on general purpose financial reports for much of the financial information they need. Consequently, they are the primary users to whom general purpose financial reports are directed. [CF.OB5].

The IASB sees the main need of such providers of capital as being information to enable them to assess: • the prospects for future net cash inflows to an entity. This is because all decisions

made by such providers of capital (whether equity investors, lenders or other creditors) depend on their assessment of the amount, timing and uncertainty of (i.e. the prospects for) the entity’s future net cash inflows [CF.OB3];

• the resources of, and claims against, the entity. These are discussed further at 2.3.2 below [CF.OB4]; and

• how efficiently and effectively the entity’s management and governing board have discharged their responsibilities to use the entity’s resources. Examples of such responsibilities include protecting the entity’s resources from unfavourable effects of economic factors such as price and technological changes and ensuring that the entity complies with applicable laws, regulations and contractual provisions. Information about management’s discharge of its responsibilities is also useful for decisions by existing providers of capital who have the right to vote on or otherwise influence management’s actions. [CF.OB4]. The discharge of management’s responsibilities referred to in this last bullet point is commonly referred to as ‘stewardship’, and indeed was described as such in the 1989 Framework (as it still is in the Introduction to the revised framework – see below). The IASB clarifies that it replaced the specific word ‘stewardship’ with this description of its underlying concepts, because of the potential difficulty of translating the word ‘stewardship’ into other languages. [CF.BC1.27-1.28].

The Conceptual Framework identifies only providers of capital as the main users of financial statements, in contrast to the 1989 Framework which referred to ‘a wide range of users’. The IASB felt it was necessary for the revised framework to focus on a more narrowly-defined group of primary users in order to avoid becoming unduly abstract or vague. [CF.BC1.14]. Moreover, the IASB attributes some of the

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inconsistency between national standards to the fact that different countries take account of the needs of different groups of users when setting national requirements. [CF Introduction.1].

However, the IASB argues that general purpose financial statements will meet the needs of most users, because they are nearly all making economic decisions, for example: • to decide when to buy, hold or sell an equity investment; • to assess the stewardship or accountability of management; • to assess the ability of the entity to pay and provide other benefits to its

employees; • to assess the security for amounts lent to the entity; • to determine taxation policies; • to determine distributable profits and dividends; • to prepare and use national income statistics; or • to regulate the activities of entities. [CF Introduction.4].

However, the IASB stresses that general purpose financial reports are not primarily directed at users other than providers of capital. [CF.OB10].

2.3.1.B Limitations The Conceptual Framework acknowledges that general purpose financial reports do not, and cannot, provide providers of capital with all the information they need. They need to consider other pertinent information, such as general economic and political conditions, and industry and company outlooks. Moreover, general purpose financial reports are not designed to show the value of a reporting entity, but to provide information to allow users to estimate it for themselves. [CF.OB6, OB7].

General purpose financial reports are focused on meeting the needs of the maximum number of primary users, who may have different, and possibly conflicting, needs for information. However, this does not preclude a reporting entity from including additional information that is most useful to a particular subset of primary users. [CF.OB8]. Management of an entity need not rely on general purpose financial reports, since the relevant information can be obtained internally. [CF.OB9].

The IASB notes that, to a large extent, financial reports are based on estimates, judgements and models rather than exact depictions. The Conceptual Framework establishes the concepts that underlie those estimates, judgements and models. The concepts should be seen as a goal which the IASB and preparers should strive towards, but are unlikely to achieve in full, at least in the short term, because it takes time to understand, accept and implement new ways of analysing transactions and other events. Nevertheless, the IASB believes that setting such a goal is essential if financial reporting is to evolve so as to improve its usefulness. [CF.OB11].

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2.3.2 Information about economic resources, claims and changes in resources and claims

General purpose financial reports provide information about: • the financial position of a reporting entity (the economic resources of, and

claims against, the entity) – see 2.3.2.A below; and • the effects of transactions and other events that change the economic

resources of, and claims against, the entity – see 2.3.2.B below.

Both types of information provide useful input for decisions about providing resources to an entity. [CF.OB12].

2.3.2.A Economic resources and claims Information about the nature and amounts of a reporting entity’s economic resources and claims can help users to: • identify the entity’s financial strengths and weaknesses; and • assess the entity’s liquidity and solvency, its needs for additional financing and

how successful it is likely to be in obtaining that financing.

Information about the priorities and payment requirements of existing claims helps users to predict how future cash flows will be distributed among lenders and creditors. [CF.OB13].

Different types of economic resources affect a user’s assessment of the entity’s prospects for future cash flows in different ways. Some future cash flows result directly from existing economic resources, such as accounts receivable. Other cash flows result from the entity using several resources in combination to produce and market goods or services to customers. Although those cash flows cannot be identified with individual economic resources (or claims), users need to know the nature and amount of the resources available for use in an entity’s operations. [CF.OB14].

2.3.2.B Changes in economic resources and claims Changes in a reporting entity’s economic resources and claims result from that entity’s financial performance and from other events or transactions such as issuing debt or equity instruments. In order to assess properly the prospects for future cash flows of the entity, users need to know the extent to which the reporting entity has increased its available economic resources, and thus its capacity for generating net cash inflows through its operations rather than by obtaining additional resources directly from providers of capital. [CF.OB15, 18, 21].

Information about a reporting entity’s financial performance helps users to understand the return that the entity has produced on its economic resources. Information about the return provides an indication of how well management has discharged its responsibilities to make efficient and effective use of the reporting entity’s resources. Information about the variability and components of that return is also important, especially in assessing the uncertainty of future cash flows. Information about a reporting entity’s past financial performance and how its management discharged its responsibilities is usually helpful in predicting the entity’s future returns on its economic resources. [CF.OB16].

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Financial performance is reflected by changes in the entity’s economic resources and claims other than by obtaining additional resources directly from providers of capital. [CF.OB15, 18]. This is sometimes described as a ‘balance sheet approach’ to recording financial performance, whereby financial performance for a period is essentially derived as part of the overall movement in the entity’s financial position during that period. This is discussed more explicitly in the section of the Conceptual Framework dealing with the elements of financial statements (see 2.6.2 below).

Consistent with this ‘balance sheet approach’, financial performance is based on accrual accounting, which depicts the effects of transactions and other events and circumstances on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period. This provides a better basis for assessing the entity’s past and future performance than information based solely on cash flows. [CF.OB17].

Information about an entity’s financial performance may also indicate the extent to which events such as changes in market prices or interest rates have changed the entity’s economic resources and claims, thereby affecting the entity’s ability to generate net cash inflows. [CF.OB19]. Nevertheless, information about an entity’s cash flows during a period also helps users to assess the entity’s ability to generate future net cash inflows, understand the entity’s operations, evaluate its financing and investing activities, assess its liquidity or solvency and interpret other information about financial performance. [CF.OB20].

2.4 Chapter 2: The reporting entity As noted at 2.2.1 above, this is a ‘space-holder’ chapter pending completion of this phase of what was originally intended as the IASB’s and FASB’s then joint project to develop an agreed framework. The IASB and FASB both published similar exposure drafts on the reporting entity in, respectively, 2008 and 2010. The IASB’s discussion paper on the Conceptual Framework issued in July 2013 (see 1 above) indicates that, although the IASB is no longer conducting this project jointly with the FASB, it will nevertheless draw upon those earlier documents, and comments received on them, in developing an exposure draft of proposed revisions to the Conceptual Framework.6

Historically there has been no clear definition of the ‘reporting entity’ and this has led to some uncertainty as to when general purpose financial statements could be prepared in accordance with IFRS. For example: • Does a reporting entity have to be a legal entity or a legal group? • Can parts only of a legal entity be a reporting entity?

The IASB’s exposure draft ED/2010/2 – Conceptual Framework for Financial Reporting – The Reporting Entity – was relatively short with three summary paragraphs: • A reporting entity is a circumscribed area of economic activities whose financial

information has the potential to be useful to existing and potential equity investors, lenders and other creditors who cannot directly obtain the information they need in making decisions about providing resources to the entity and in assessing whether the management and the governing board of that entity have made efficient and effective use of the resources provided.

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• An entity controls another entity when it has the power to direct the activities of that other entity to generate benefits for (or limit losses to) itself. If an entity that controls one or more entities prepares financial reports, it should present consolidated financial statements.

• A portion of an entity could qualify as a reporting entity if the economic activities of that portion can be distinguished objectively from the rest of the entity and financial information about that portion of the entity has the potential to be useful in making decisions about providing resources to that portion of the entity.

In essence, under these proposals a reporting entity has three features: • economic activities have been, are being or will be conducted; • those activities can be distinguished from those of other entities or of the rest

of the entity; and • financial information about the entity’s economic activities has the potential to

be of value in making decisions about providing resources to that entity.7 This provides a rather broad definition and its key implication is that a reporting entity could be: • a single legal entity (although if the activities of that entity are mixed with

others it might not);8 • a part of a legal entity;9 or • a combination of legal entities (and by extension parts of a legal entity) which

are under common control – financial statements of such an entity are commonly called ‘combined financial statements’.10

Although the exposure draft is clear that, if an entity controls another entity, it must prepare consolidated financial statements, the Boards are not proposing to include detailed guidance about the meaning of control in the finalised framework. Rather they believe it should be provided at the detailed standard level and hence control is discussed in only general terms in the exposure draft.

The exposure draft also notes that a controlling entity may present ‘parent only financial information’ so long as this is presented together with consolidated financial statements11 – a conclusion which reconfirms the current position.

The wide scope of the definition proposed in the exposure draft means that, in practice, deciding whether or not something is a reporting entity will require considerable judgement. For example whether the operations of a legal entity (A) are so mingled with those of another (B) such that A is not a reporting entity is likely to prove a very vexed question. However such practical issues would in most cases be addressed by clear disclosure of the judgements made in determining the reporting entity and the basis on which the financial statements have been prepared.

After publication of the exposure draft, the IASB and FASB indicated that, before finalising the chapter, they would like to discuss further the relevance to the project of some fundamental concepts. These would include: • the circumstances that allow for combined financial statements, and • the effect of an entity’s ownership structure as it applies to, and affects, the

usefulness of reported financial information, chiefly equity and net income.12

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2.5 Chapter 3: Qualitative characteristics of useful financial information The Conceptual Framework states that the types of information likely to be most useful to providers of capital are identified by various qualitative characteristics, [CF.QC1], comprising: • two ‘fundamental qualitative characteristics’ (see 2.5.1 below):

• relevance; and • faithful representation; [CF.QC5], supplemented by

• four ‘enhancing qualitative characteristics’ (see 2.5.2 below): • comparability; • verifiability; • timeliness; and • understandability. [CF.QC19].

Chapter 3 of the Conceptual Framework also notes the role of cost as a ‘pervasive constraint’ on a reporting entity’s ability to provide useful financial information. This is discussed further at 2.5.3 below.

The relationship between the objective, fundamental characteristics, enhancing characteristics and the pervasive cost constraint can be represented diagrammatically as follows:

Figure 2.1  Components of the Conceptual Framework 

Financial reports provide information about the reporting entity’s economic resources, claims against the reporting entity and the effects of transactions and other events and conditions that change those resources and claims (collectively referred to in the Conceptual Framework as ‘the economic phenomena’). Some financial reports also include explanatory material about management’s expectations and strategies for the reporting entity, and other types of forward-looking information. [CF.QC2].

• Completeness• Neutrality• Free from error

• Predictive value• Confirmatory value• Entity-specific materiality

Provide useful information to existing and future investors, lenders and other creditorsObjective

Fundamental characteristics Relevance Faithful representation

Enhancing characteristics

Pervasive constraint

Comparability Verifiability Timeliness Understandability

Cost

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The qualitative characteristics of useful financial information apply to all financial information, whether provided in financial statements or in other ways. All financial information is also subject to a pervasive cost constraint on the reporting entity’s ability to provide useful financial information. However, the considerations in applying the qualitative characteristics and the cost constraint may be different for different types of information. For example, applying them to forward-looking information may be different from applying them to information about existing economic resources and claims and to changes in those resources and claims. [CF.QC3].

2.5.1 Fundamental qualitative characteristics In order to be useful, financial information must be relevant (see 2.5.1.A below) and faithfully represent what it purports to represent (see 2.5.1.B below). [CF.QC4].

2.5.1.A Relevance (including materiality) Relevant financial information is that which is capable of making a difference to the decisions made by users, irrespective of whether some users choose not to take advantage of it or are already aware of it from other sources. Financial information is capable of making a difference in decisions if it has predictive value, confirmatory value or both. [CF.QC6, QC7].

Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcomes. Financial information with predictive value need not itself be a prediction or forecast, but is employed by users in making their own predictions. Financial information has confirmatory value if it confirms or changes previous evaluations. [CF.QC8, QC9].

The predictive value and confirmatory value of financial information are interrelated. For example, information on revenue for the current year can be used both as the basis for predicting revenues in future years, and as a point of comparison with predictions made in prior years of revenue for the current year. The results of those comparisons can help a user to correct and improve the processes that were used to make those previous predictions. [CF.QC10].

The Conceptual Framework refers to materiality as ‘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’. In other words, information is material (and therefore relevant) if omitting or misstating it could influence the decisions of users of financial information about a specific reporting entity. Because of the specificity of materiality to a particular reporting entity, the IASB cannot specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation. [CF.QC11].

2.5.1.B Faithful representation The Conceptual Framework observes that financial reports represent economic phenomena in words and numbers. To be useful, financial information must not only

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represent relevant phenomena, but it must also faithfully represent the phenomena that it purports to represent. A perfectly faithful representation would be: • complete, • neutral, and • free from error.

The IASB’s objective is to maximise those qualities to the extent possible, while acknowledging that perfection is seldom, if ever, achievable. [CF.QC12].

A complete depiction includes all information, including all necessary descriptions and explanations, necessary for a user to understand the phenomenon being depicted. For example, a complete depiction of a group of assets would include, at a minimum: • a description of the nature of the assets; • a numerical depiction of the assets; and • a description of what the numerical depiction represents (for example, original

cost, adjusted cost or fair value).

For some items, a complete depiction may also entail explanations of significant facts about the quality and nature of those items, factors and circumstances that might affect their quality and nature, and the process used to determine the numerical depiction. [CF.QC13].

A neutral depiction is one without bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasised, de-emphasised or otherwise manipulated to increase the probability that financial information will be received favourably or unfavourably by users. That is not to imply that neutral information has no purpose or no influence on behaviour. On the contrary, relevant financial information is, by definition, capable of making a difference in users’ decisions. [CF.QC14].

The Conceptual Framework stresses that the term ‘free from error’ does not necessarily imply that information is accurate in all respects. Rather, information is ‘free from error’ if there are no errors or omissions either in the description of the economic phenomenon being depicted or in the selection or application of the process used to produce the reported information. For example, an estimate of an unobservable price or value cannot be determined to be accurate or inaccurate. However, a representation of that estimate can be faithful if the amount is described clearly and accurately as being an estimate, the nature and limitations of the estimating process are explained, and no errors have been made in selecting and applying an appropriate process for developing the estimate. [CF.QC15].

The Conceptual Framework also notes the apparent paradox that a faithful representation does not, by itself, necessarily result in useful information. It gives the example of a reporting entity receiving property, plant and equipment at no cost through a government grant. To report that the entity had acquired an asset at no cost would be a faithful representation of the cost of the asset, but the resulting information would probably not be very useful.

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Another example is an estimate of the adjustment required to the carrying amount of an impaired asset. That estimate can be a faithful representation if the entity has properly applied an appropriate process, properly described the estimate and explained any uncertainties that significantly affect the estimate. However, an estimate subject to a high level of uncertainty will not be particularly useful. In other words, ‘the relevance of the asset being faithfully represented is questionable’. If there is no alternative representation that is more faithful, that estimate may provide the best available information. [CF.QC16]. Some may be surprised by the implication that information of questionable relevance about an economic phenomenon may nevertheless give a faithful representation of that phenomenon.

The IASB notes that a faithful representation requires a transaction to be reported in accordance with its economic substance rather than its legal form. [CF.BC3.26].

The characteristic of ‘faithful representation’ in the 2010 Conceptual Framework replaces that of ‘reliability’ in the 1989 Framework, which defined it in the following terms: ‘Information has the quality of reliability when it is free from material error and

bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent’.

The IASB explains that it decided to replace the term ‘reliability’ because there was a lack of clarity as to its meaning both in the 1989 Framework and the original FASB Concepts Statement 2, from which the 1989 Framework was derived. Moreover, the IASB notes that comments received on numerous proposed standards have indicated a lack of a common understanding of the term ‘reliability’. Some respondents ‘focused on verifiability or free from material error to the virtual exclusion of faithful representation. Others focused more on faithful representation, perhaps combined with neutrality’. The IASB appears surprised that some respondents ‘apparently think that reliability refers primarily to precision’, even though precision is intrinsic to the normal English meaning of ‘reliability’. For these reasons, the IASB decided to replace ‘reliability’ with what it regards as the more precisely defined ‘faithful representation’. [CF.BC3.20-BC3.26].

2.5.1.C Applying the fundamental qualitative characteristics In order to be useful, information must be both relevant and provide a faithful representation. In the IASB’s words ‘neither a faithful representation of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon helps users make good decisions’.

The most efficient and effective process for applying the fundamental qualitative characteristics would, subject to the effects of the enhancing qualitative characteristics (see 2.5.2 below) and the cost constraint (see 2.5.3 below), usually be as follows: • identify an economic phenomenon that has the potential to be useful to users

of the reporting entity’s financial information; • identify the type of information about that phenomenon that would be most

relevant if it were available and able to be faithfully represented; and • determine whether that information is in fact available and able to be faithfully

represented.

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If so, the process of satisfying the fundamental qualitative characteristics ends at that point. If not, the process is repeated with the next most relevant type of information. [CF.QC17, QC18].

2.5.2 Enhancing qualitative characteristics The usefulness of relevant and faithfully represented financial information is enhanced by the characteristics of comparability (see 2.5.2.A below), verifiability (see 2.5.2.B below), timeliness (see 2.5.2.C below) and understandability (see 2.5.2.D below). These enhancing characteristics may also help determine which of two ways should be used to depict a phenomenon if both are considered equally relevant and faithfully represented. [CF.QC4, QC19].

2.5.2.A Comparability The IASB notes that decisions made by users of financial information involve choices between alternatives, such as selling or holding an investment, or investing in one entity or another. Consequently, information about a reporting entity is more useful if it can be compared with similar information about other entities, and about the same entity for another period or as at another date. [CF.QC20].

Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items. Unlike the other qualitative characteristics, comparability does not relate to a single item, since – by definition – a comparison requires at least two items. The IASB clarifies that, for information to be comparable, like things must look alike and different things must look different, adding that ‘comparability of financial information is not enhanced by making unlike things look alike any more than it is enhanced by making like things look different.’ [CF.QC21-QC23]. Although a single economic phenomenon can be faithfully represented in more than one way, permitting alternative accounting methods for the same economic phenomenon diminishes comparability. [CF.QC25].

The Conceptual Framework stresses that consistency (i.e. the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities) helps to achieve comparability, but is not the same as comparability. The IASB adds that comparability is not the same as uniformity, but without any definition of ‘uniformity’ or clarification of how it differs from comparability. Some degree of comparability is likely to be attained simply by satisfying the fundamental qualitative characteristics. In other words, a faithful representation of a relevant economic phenomenon by one entity should naturally be comparable with a faithful representation of a similar relevant economic phenomenon by another entity. [CF.QC23, QC24].

2.5.2.B Verifiability Verifiability helps assure users that information faithfully represents the economic phenomena that it purports to depict. Verifiability means that different knowledgeable and independent observers could reach a consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Quantified information need not be a single point estimate to be verifiable. A range of possible amounts and their related probabilities can also be verified. [CF.QC26].

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The IASB notes that verification can be direct or indirect. Direct verification means verifying an amount or other representation through direct observation. Indirect verification means checking the inputs to a model, formula or other technique and recalculating the outputs using the same methodology. Some explanations and forward-looking financial information may not be verifiable until a future period, if at all. To help users decide whether to use such information, it would normally be necessary to disclose the assumptions, other factors and circumstances underlying the information, together with the methods of compiling the information. [CF.QC27-QC28].

2.5.2.C Timeliness Timeliness means that information is available to decision-makers in time to be capable of influencing their decisions. Generally, the older the information is the less useful it is. However, some information may continue to be timely long after the end of a reporting period, for example because some users may need to identify and assess trends. [CF.QC29].

2.5.2.D Understandability Information is made understandable by classifying, characterising and presenting it clearly and concisely. [CF.QC30]. The IASB concedes that some phenomena are so inherently complex and difficult to understand that financial reports might be easier to understand if information about those phenomena were excluded. However, reports prepared without that information would be incomplete and therefore potentially misleading. Moreover, financial reports are prepared for users with a reasonable knowledge of business and economic activities who can review and analyse the information diligently. Even such users, however, may need to seek specialist advice in order to understand information about complex economic phenomena. [CF.QC31, QC32].

2.5.2.E Applying the enhancing qualitative characteristics The Conceptual Framework stresses that, while the enhancing qualitative characteristics should be maximised to the extent possible, they cannot, either individually or as a group, make information useful if that information is irrelevant or not faithfully represented. [CF.QC33].

Applying the enhancing qualitative characteristics is an iterative process that does not follow a prescribed order. Sometimes, one enhancing qualitative characteristic may have to be diminished in order to maximise another. For example, applying a new financial reporting standard prospectively (i.e. with no restatement of prior periods) will reduce comparability in the short term. However, that may be a price worth paying for improved relevance or faithful representation in the longer term. Appropriate disclosures may partially compensate for the lack of comparability. [CF.QC34].

2.5.3 The cost constraint The IASB acknowledges that cost is a pervasive constraint on the information provided by financial reporting, and that the cost of producing information must be justified by the benefits that it provides. Interestingly, the IASB argues that, while there is clearly an explicit cost to the preparers of financial information, the cost is

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ultimately borne by users, since any cost incurred by the reporting entity reduces the returns earned by users. In addition, users incur costs not only in analysing and interpreting any information that is provided, but also in obtaining or estimating any information that is not provided. [CF.QC35, QC36, QC38].

Relevant and faithfully representative financial information helps users to make decisions with more confidence, resulting in a more efficient functioning of capital markets and a lower cost of capital for the economy as a whole. An individual provider of capital also receives benefits by making more informed decisions. However, it is not possible for general purpose financial reports to provide all information relevant to every user. [CF.QC37].

In assessing whether the benefits of reporting particular information are likely to justify the cost, the IASB seeks information from providers of financial information, users, auditors, academics and others about the expected nature and quantity of the benefits and costs of that standard. In most situations, assessments are based on a combination of quantitative and qualitative information, and will normally be considered in relation to financial reporting generally, and not in relation to individual reporting entities. However, an assessment of costs and benefits will not always justify the same reporting requirements for all entities. Differences may be appropriate because of different sizes of entities, different ways of raising capital (publicly or privately), different needs of users or other factors. [CF.QC38, QC39].

2.6 Chapter 4: The Framework (1989): the remaining text Chapter 4 of the Conceptual Framework essentially represents those parts of the 1989 Framework not superseded as the result of the completion of Phase A of the then joint IASB-FASB framework project (see 1 above). It comprises: • Underlying assumption (see 2.6.1 below); • The elements of financial statements (see 2.6.2 below); • Recognition of the elements of financial statements (see 2.6.3 below); • Measurement of the elements of financial statements (see 2.6.4 below); and • Concepts of capital and capital maintenance (see 2.6.5 below).

2.6.1 Underlying assumption (going concern) Financial statements are normally prepared on the assumption that the reporting entity is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to liquidate or curtail materially the scale of its operations. If such an intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed. [CF.4.1].

2.6.1.A Possible future developments The IASB’s discussion paper on the framework (see 1 above) suggests that, in the IASB’s view, an entity’s ability to continue as a going concern affects the following (and only the following) aspects of financial reporting:

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• the recognition of liabilities that arise only on liquidation (since these do not meet the definition of a present obligation while the entity is a going concern – see 2.6.2.C below);

• the measurement of assets and liabilities (since the contribution of assets to future cash flows and the settlement of liabilities are both affected by a change in the entity’s ability to continue as a going concern); and

• the disclosures to be made by an entity.13

2.6.2 The elements of financial statements Financial statements portray the financial effects of transactions and other events by grouping them according to their economic characteristics into broad classes termed the elements of financial statements. The elements directly related to the measurement of financial position in the statement of financial position are assets, liabilities and equity. The elements directly related to the measurement of performance in the income statement are income and expenses. The framework identifies no elements that are unique to the statement of changes in equity, since this is comprised of items that appear in the statement of financial position or the income statement, or both. [CF.4.2].

These elements are typically subject to further sub-classification before presentation in the statement of financial position and the income statement. For example, assets and liabilities may be classified by their nature or function in order to display information in the most useful manner to users. [CF.4.3].

2.6.2.A Statement of financial position The elements related to the measurement of financial position are assets, liabilities and equity.

An asset is ‘a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.’ Assets are discussed further at 2.6.2.B below.

A liability is ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.’ Liabilities are discussed further at 2.6.2.C below.

Equity is ‘the residual interest in the assets of the entity after deducting all its liabilities.’ Equity is discussed further at 2.6.2.D below. [CF.4.4]

The Conceptual Framework stresses that an item that meets the definition of an asset or a liability is not necessarily recognised in the financial statements. An asset or liability is recognised only where there is a sufficient certainty that there will be a future inflow or outflow of economic benefit. [CF.4.5]. Recognition is discussed more generally at 2.6.3 below.

Any assessment of whether an item meets the definition of an asset, liability or equity must have regard to its underlying substance and economic reality, and not merely its legal form. For example, a finance lease economically gives the lessee a right (which meets the definition of an asset) to use the leased asset for most of its

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useful life and liability to pay for that right an amount approximating to the fair value of the right plus a finance charge. Hence, a finance lease gives rise to the recognition of both an asset and a liability. [CF.4.6].

The Conceptual Framework comments that specific IFRSs may require items that do not meet the definitions of ‘asset’ or ‘liability’ to be recognised in the statement of financial position. Nevertheless, these definitions will underpin reviews of existing IFRSs, and the development of new standards. [CF.4.7]. The Conceptual Framework does not give examples of such items, but some would argue that they include: • goodwill (since this is not controlled by the entity); and • deferred taxes (since these represent the amount by which future assets or

liabilities will be greater or less than they would have been but for the occurrence of one or more past transactions or events, rather than present assets or liabilities).

2.6.2.B Assets As noted in 2.6.2.A above, a characteristic of an asset is that future economic benefits are expected to flow from it. Those ‘future economic benefits’ are the potential for the asset to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity. This may be a productive potential, forming part of the operating activities of the entity. It may also take the form of convertibility into cash or cash equivalents or a capability to reduce cash outflows, such as when an alternative manufacturing process lowers the costs of production. [CF.4.8].

Assets are typically deployed in order to produce goods or services for customers, who are prepared to pay for them and hence contribute to the cash flow of the entity. Cash – it is asserted – itself renders a service to the entity because of its command over other resources. [CF.4.9].

An asset may give rise to an inflow of future economic benefits to the entity in a number of ways, for example by being: • used (singly or in combination with other assets) in the production of goods or

services to be sold by the entity; • exchanged for other assets; • used to settle a liability; or • distributed to the owners of the entity. [CF.4.10].

Many assets, such as property, plant and equipment, have a physical form. However, physical form is not essential to the existence of an asset. For example, patents and copyrights are assets if future economic benefits are expected to flow from them to the entity and if they are controlled by the entity. [CF.4.11].

Many assets, such as receivables and property, are associated with legal rights, including the right of ownership. However, ownership is not essential in determining the existence of an asset. For example, leased property is an asset if the entity controls the benefits which are expected to flow from the property. Some items may satisfy the definition of an asset even when there is no legal control, such as internally generated know-how where, by keeping the know-how secret, the entity controls the benefits that are expected to flow from it. [CF.4.12].

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Assets of an entity result from past transactions or other past events. Assets are normally purchased or produced, but they may arise from other transactions or events. For example, government may transfer property to an entity to encourage economic growth in an area, or the entity may discover mineral deposits. An expected future transaction or event (such as an intention to purchase inventory) does not give rise to an asset. [CF.4.13].

The Conceptual Framework notes that there is a close – but not a necessary – link between incurring expenditure and generating assets. Expenditure may provide evidence that future economic benefits were sought, but is not conclusive proof that an asset has been obtained. Similarly, the absence of expenditure does not indicate that no asset has been obtained. For example, an item donated to the entity may satisfy the definition of an asset. [CF.4.14].

The definition of an asset in the Conceptual Framework is adopted from the FASB’s framework, with one important difference. The US framework refers to benefits ‘obtained or controlled’, by the entity, while the IASB’s definition refers solely to resources ‘controlled’ by the entity. This has the effect, as noted above, that goodwill (which the IASB itself acknowledges to be an asset) may fall outside the definition of ‘asset’ in the IASB’s own framework.

This shortcoming in the current definition may be tacitly acknowledged by the fact that the discussion of the objective of general purpose financial reporting now refers to information about the economic resources ‘of’ an entity (see 2.3.2 above), whereas the equivalent discussion in the 1989 Framework referred to the economic resources ‘controlled by’ an entity.

In its recent discussion paper on the Conceptual Framework (see 1 above), the IASB has indicated that it proposes to change the definition of an asset to ‘a present economic resource controlled by the entity as the result of past events’. The IASB believes that this will improve the definition by confirming more explicitly that: • an asset is a resource in its own right (rather than simply the inflow of

resources that it may generate); and • an asset must be capable of generating inflows, but those inflows need not be

certain. The uncertainty of future inflows would influence whether an asset is recognised, but not whether it is an asset.14

The discussion paper also notes that the current framework does not define ‘control’ in the context of the definition of an asset. The IASB proposes to clarify that ‘an entity controls an economic resource if it has the present ability to direct the economic resource so as to obtain the economic benefits that flow from it.’ This definition draws on definitions of ‘control’ in other IFRSs, in particular IFRS 10 – Consolidated Financial Statements – and IAS 18 – Revenue.15

2.6.2.C Liabilities An essential characteristic of a liability is that the entity has a present obligation (that is, a duty or responsibility to act or perform in a certain way). An obligation may be legally enforceable under a binding contract or statutory requirement. This is normally the case for amounts payable for goods and services received. However,

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obligations also arise, from normal business custom and practice, or a desire to maintain good business relations or act in an equitable manner. For example, if an entity has a policy to rectify product faults, even when these become apparent after the warranty period has expired, the amounts that are expected to be expended in respect of goods already sold are liabilities. [CF.4.15]. Such non-legally binding obligations are reflected in the concept of the ‘constructive obligation’ in IAS 37 – Provisions, Contingent Liabilities and Contingent Assets (see Chapter 27 at 3.1.1).

The Conceptual Framework stresses that a decision by management – for example to acquire an asset – does not, of itself, give rise to a present obligation. An obligation normally arises only when the asset is delivered, or the entity enters into an irrevocable agreement to acquire it. Such an agreement typically provides for substantial financial penalty for failing to honour the obligation, leaving the entity with little or no discretion to avoid the outflow of resources. [CF.4.16]. This distinction between decisions of management and actual obligations or commitments is a significant feature of IAS 37 (see Chapter 27, particularly at 5).

The settlement of a present obligation usually involves the entity giving up resources embodying economic benefits in order to satisfy the claim of the other party, for example, by: • payment of cash; • transfer of other assets; • provision of services; • replacement of the obligation being settled with another obligation; or • conversion of the obligation to equity.

An obligation may also be extinguished by other means, such as a creditor waiving or forfeiting its rights. [CF.4.17].

Liabilities result from past transactions or other past events. Thus, for example, the acquisition of goods or the use of services gives rise to trade payables (unless paid for in advance or on delivery), and the receipt of a bank loan results in an obligation to repay it. A liability may arise for a rebate offered to customers for minimum levels of purchases. In this case, the sale of the goods in the past is the transaction that gives rise to the liability. [CF.4.18].

Liabilities that can be measured only by using a substantial degree of estimation (often described as provisions) are liabilities as defined in the Conceptual Framework. A provision that involves a present obligation, and satisfies the rest of the definition, is a liability even if its amount has to be estimated. Examples include a provision for payments to be made under existing warranties and a provision to cover pension obligations. [CF.4.19]. Provisions are discussed more broadly in Chapter 27.

In its discussion paper on the Conceptual Framework (see 1 above), the IASB has indicated that it proposes to change the definition of a liability to ‘a present obligation of the entity to transfer an economic resource as the result of past events’. The IASB believes that this will improve the definition by confirming more explicitly that:

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• a liability is an obligation in its own right (rather than simply the outflow of economic benefits that it may generate); and

• a liability must be capable of generating outflows, but those outflows need not be certain. The uncertainty of future outflows would influence whether a liability is recognised, but not whether it is a liability.16 This is not dissimilar from the approach of IAS 37 (see Chapter 27).

The discussion paper also notes that the current framework is not clear as to what constitutes a ‘present’ obligation and discusses three broad approaches that could be taken: • View 1 – a liability must have arisen from past events and be absolutely

unconditional. In other words, there is nothing that the entity can do to avoid the liability.

• View 2 – a liability must have arisen from past events and be practically unconditional. In other words, there are steps that the entity could take to avoid the liability, but they are so drastic as to be commercially impossible in practice.

• View 3 – a liability must have arisen from past events but its crystallisation may be conditional on future actions of the entity.

The IASB has tentatively rejected View 1, but has yet to conclude on whether it favours View 2 or View 3.17 Interestingly, the IASB explicitly rejects the concept of ‘economic compulsion’ as the basis for recognising a liability,18 yet View 2 above seems very close to describing a scenario that many people would characterise as economic compulsion. The IASB will need to consider this issue further as it reaches a conclusion on which view of the definition of ‘liability’ it favours.

The discussion paper also notes the lack of clarity in the current framework and standards as to the boundary between liabilities and equity. For example, financial instruments settled in equity where the issuing entity bears some risk of the value of its own equity are accounted for as liabilities (see Chapter 44). However, share-based payment transactions settled in equity are treated as equity whether or not the entity bears any risk of the value of its own equity (see Chapter 31).

The discussion paper proposes an interesting approach to resolving these inconsistent approaches. Changes in value of a transaction settled in the entity’s own equity would be distinguished between those changes that affect the entity as a whole (recognised in comprehensive income) and those changes that affect only the relative interests in the entity of holders of different classes of equity (recognised within equity).19 This is discussed further in Chapter 31 at 1.4 and Chapter 44 at 12.

2.6.2.D Equity Although equity is defined as a residual amount (assets less liabilities – see 2.6.2.A above), it may be sub-classified in the statement of financial position. A corporate entity might classify its total equity into: • funds contributed by shareholders; • retained earnings; • reserves representing appropriations of retained earnings; and • reserves representing capital maintenance adjustments.

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Such classifications can be relevant to the decision-making needs of the users of financial statements when they indicate legal or other restrictions on the ability of the entity to distribute or otherwise apply its equity. They may also reflect the differing rights of parties with ownership interests as regards dividends or the repayment of contributed equity. [CF.4.20].

Statute or other law may require the entity to create reserves in order to protect the entity and its creditors from the effect of losses. National tax law may grant exemptions from, or reductions in, taxation liabilities when transfers are made to such reserves. The existence and size of these legal, statutory and tax reserves is information that can be relevant to the decision-making needs of users. However, transfers to such reserves are appropriations of retained earnings rather than expenses. [CF.4.21].

The amount of equity in the statement of financial position depends on the measurement of assets and liabilities. Other than by coincidence, the carrying amount of equity will not normally correspond to the aggregate market value of the shares of the entity, or to the sum that could be raised by disposing of either the net assets on a piecemeal basis or the entity as a whole on a going concern basis. [CF.4.22].

Commercial, industrial and business activities are often undertaken by means of entities such as sole proprietorships, partnerships and trusts and various types of government business undertakings. The legal and regulatory framework for such entities is often different from that applying to corporate entities. For example, there may be few or no restrictions on distributions to owners. Nevertheless, the definition of equity and the other aspects of the Conceptual Framework that deal with equity are appropriate for such entities. [CF.4.23].

As noted at 2.6.2.C above, the discussion paper on the Conceptual Framework issued by the IASB in July 2013 (see 1 above) notes the lack of clarity in the current framework and standards as to the boundary between liabilities and equity.

2.6.2.E Performance Profit is frequently used as a measure of performance or as the basis for other measures, such as return on investment or earnings per share. The elements directly related to the measurement of profit are income and expenses. The recognition and measurement of income and expenses, and hence profit, depend in part on the concepts of capital and capital maintenance used by the entity in preparing its financial statements (see 2.6.5 below). [CF.4.24].

Income is ‘increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants’. Income is discussed at 2.6.2.F below.

Expenses are ‘decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants’. Expenses are discussed at 2.6.2.G below. [CF.4.25].

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As is the case with assets and liabilities (see 2.6.2.A above), items may meet the definitions of income and expenses but not satisfy the requirements of the Conceptual Framework for recognition in the income statement. [CF.4.26]. The recognition criteria are discussed at 2.6.3 below.

Income and expenses may be presented in the income statement in different ways. In particular, items of income and expenses that arise in the course of the ordinary activities of the entity are commonly differentiated from those that do not. This helps users to evaluate the entity’s ability to generate cash in the future (since incidental activities such as the disposal of a long-term investment are unlikely to recur on a regular basis). Any such distinction between items must have regard to the nature of the entity and its operations. Items that arise from the ordinary activities of one entity may be unusual in respect of another. [CF.4.27]. This section of the Conceptual Framework has perhaps not been kept fully up to date with more recent developments, as discussed in Chapter 3 at 3.2.6.

Distinguishing between items of income and expense and combining them in different ways also permits an entity to display several measures of performance with differing degrees of inclusiveness. For example, the income statement could display gross margin, profit or loss from ordinary activities before taxation, profit or loss from ordinary activities after taxation, and profit or loss. [CF.4.28].

The discussion paper on the Conceptual Framework issued by the IASB in July 2013 (see 1 above) notes that the statement of comprehensive income currently required to be prepared under IFRSs contains two sections (profit or loss and other comprehensive income). These two sections have evolved on a rather piecemeal basis with no clear conceptual distinction between them. The discussion paper proposes various approaches that might be taken to address this, which are discussed in more detail in Chapter 3 at 6.2.

2.6.2.F Income Income encompasses both revenue and gains. Revenue arises in the course of the ordinary activities of an entity. Gains are other items that meet the definition of income whether or not they arise in the course of the ordinary activities of an entity. Because gains represent increases in economic benefits, they are no different in nature from revenue, and are not regarded a separate element in the Conceptual Framework. [CF.4.29-30].

The IASB gives this analysis, in part, in order to explain why it did not follow the approach of the US conceptual framework, which distinguishes revenue from gains, and further differentiates gains arising from central operations from those that do not.

Gains include, for example, those arising on the disposal of non-current assets. The definition of income also includes unrealised gains, such as those arising from the revaluation of marketable securities, exchange differences or increases in the carrying amount of long-term assets. Gains recognised in the income statement are usually displayed separately and are often reported net of related expenses. [CF.4.31].

Income gives rise to the receipt, or enhancement, of various kinds of assets. For example, cash, receivables and goods and services may be received in exchange for

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goods and services supplied. Income may also result from the settlement of liabilities. For example, an entity may provide goods and services to a lender in lieu of cash settlement of an outstanding loan. [CF.4.32].

2.6.2.G Expenses The definition of expenses encompasses losses as well as expenses arising in the course of ordinary activities, such as cost of sales, wages and depreciation. Expenses usually take the form of an outflow or depletion of assets such as cash and cash equivalents, inventory, property, plant and equipment. [CF.4.33].

Losses represent other items that meet the definition of expenses, whether or not they arise in the course of the ordinary activities of the entity. Losses represent decreases in economic benefits. As such, they are no different in nature from other expenses and are not regarded as a separate element in the Conceptual Framework. [CF.4.34].

Examples of losses include those resulting from disasters such as fire and flood, and arising on the disposal of non-current assets. The definition of expenses also includes unrealised losses, such those arising from the revaluation of marketable securities or exchange rate differences. Losses recognised in the income statement are usually displayed separately because knowledge of them is useful for the purpose of making economic decisions, and are often reported net of related income. [CF.4.35].

2.6.2.H Realisation The realisation principle – that income and expenditure, particularly income, should be recognised only when its conversion into cash has occurred or is reasonably certain – is a fundamental concept in a number of national GAAPs, for example those of members of the European Union.

The realisation principle is not discussed in the Conceptual Framework, except to the extent that it is made clear that income and expenses include both realised and unrealised gains and losses (see 2.6.2.E and 2.6.2.F above). However, the realisation principle appears to have significantly influenced the distinction between items required to be included in profit or loss and those required to be included in other comprehensive income (see 2.6.2.E above). Many (but not all) items included in other comprehensive income under IFRS would generally be regarded as unrealised.

2.6.2.I Transactions with owners acting in another capacity The Conceptual Framework does not address the treatment of transactions with an owner of the reporting entity who also transacts with the entity in another capacity. Such transactions may take many forms, for example: • an owner may be paid for the provision of goods or services to the entity; or • a shareholder may lend cash to the entity.

In our view the nature of such transactions needs to be considered on a case-by-case basis. Where an owner supplies goods or services on arm’s length terms, the presumption must be that the consideration paid by the entity is paid to the owner in his capacity as a supplier (an expense) rather than in his capacity as an

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owner (a distribution). Where, however, the amount paid is significantly lower or higher than the arm’s length price, the entity needs to consider whether the transaction in fact comprises two elements: • an expense for the arm’s length price; and • either a distribution to, or contribution from, the owner for any amount paid,

respectively, in excess of or below the arm’s length price.

This is discussed in the context of intragroup transactions in Chapter 8.

Similarly, where an owner makes a loan to the entity on arm’s length terms, the presumption would be that the loan is made in the owner’s capacity as lender (a financial liability) rather than as owner (an increase in equity). If, however, the loan is subsequently forgiven, it will generally be a more appropriate analysis that the shareholder acts in the capacity of an owner (an increase in equity) rather than in the capacity as lender (a gain). This is because a third-party lender would be extremely unlikely to forgive a loan for no consideration, whereas it is entirely consistent for an owner of a distressed business to choose to inject more capital.

2.6.2.J Capital maintenance adjustments The Conceptual Framework notes that the revaluation or restatement of assets and liabilities gives rise to increases or decreases in equity that meet the definition of income and expenses, but – under certain concepts of capital maintenance – are included in equity as capital maintenance adjustments or revaluation reserves. [CF.4.36]. Concepts of capital maintenance are discussed at 2.6.5 below.

2.6.3 Recognition of the elements of financial statements An item is recognised in the financial statements when: • it meets the definition of an element (see 2.6.2 above); • it is probable that any future economic benefit associated with the item will

flow to or from the entity (see 2.6.3.A below); and • the item has a cost or value that can be measured reliably (see 2.6.3.B below).

Recognition involves the depiction of the item in words and by a monetary amount, and the inclusion of that amount in the financial statements. A failure to recognise an item meeting these criteria is not rectified by disclosure of the accounting policies used nor by notes or explanatory material. The entity must consider the materiality of an item in assessing whether it qualifies for recognition in the financial statements. [CF.4.37-39].

An item that fails to meet the recognition criteria above at a particular point in time may qualify for recognition at a later date as a result of subsequent circumstances or events. [CF.4.42].

2.6.3.A Probability of future economic benefit or outflow The recognition criteria above use the concept of probability to refer to the degree of uncertainty that future economic benefits will flow to or from the entity. Assessments of the degree of uncertainty attaching to the flow of future economic benefits are made on the basis of the evidence available when the financial statements are prepared. For example, it is appropriate to recognise a receivable as

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an asset when it is probable that it will be paid. For a large population of receivables, however, because some non-payment is normally considered probable, an expense representing the expected reduction in economic benefits is recognised. [CF.4.40].

2.6.3.B Reliability of measurement A further criterion for the recognition of an item is that it can be measured reliably, which, the Conceptual Framework notes (perhaps surprisingly) will include the use of ‘reasonable estimates’ where necessary. However, when a reasonable estimate cannot be made, the item is not recognised. An item that fails to meet the criteria for recognition may nonetheless warrant disclosure in the notes or other explanatory material, when knowledge of the item is relevant to the evaluation of the entity by the users of financial statements.

For example, the expected proceeds from a lawsuit may meet the definitions of ‘asset’ and ‘income’ and satisfy the probability criterion for recognition. However, if it is not possible for the claim to be measured reliably, it should not be recognised, although its existence would be disclosed in the notes or other explanatory material. [CF.4.41,43].

2.6.3.C Recognition of assets As discussed above, an asset is recognised when it is probable that future economic benefits will flow to the entity and the asset can be measured reliably. Conversely, an asset is not recognised when expenditure has been incurred for which it is considered improbable that economic benefits will flow to the entity beyond the current accounting period – such a transaction results in an expense. This does not imply either that management incurred expenditure with no intention to generate future economic benefits or that management was misguided. The only implication is that it is not sufficiently certain that economic benefits will flow to the entity beyond the current accounting period to warrant the recognition of an asset. [CF.4.44-45].

2.6.3.D Recognition of liabilities A liability is recognised in the balance sheet when it is probable that the settlement of a present obligation will result in an outflow of economic benefits that can be measured reliably. In practice, liabilities are not generally recognised for obligations under executory contracts that are unperformed to the same extent by both parties (for example, liabilities for inventory ordered but not yet received). However, such obligations may meet the definition of liabilities and, provided the recognition criteria are met in the particular circumstances, may qualify for recognition. In such circumstances, recognition of liabilities entails recognition of related assets or expenses. [CF.4.46].

2.6.3.E Recognition of income Income is recognised when there has been an increase in an asset or decrease of a liability that can be measured reliably. Procedures adopted in practice for recognising income (for example, the requirement that revenue should be earned) are applications of the recognition criteria in the Conceptual Framework, aimed at ensuring that items are recognised as income only when they can be measured reliably and have a sufficient degree of certainty. [CF.4.47-48].

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2.6.3.F Recognition of expenses An expense is recognised when there has been a decrease of an asset or increase in a liability that can be measured reliably. Expenses are recognised in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income (commonly referred to as ‘matching’). For example, the various components of expense making up the cost of goods sold are recognised at the same time as the income from the sale. However, the Conceptual Framework does not allow ‘matching’ when it would result in the recognition of items in the balance sheet that do not meet the definition of assets or liabilities. [CF.4.49-50].

When economic benefits associated with expenditure arise over several accounting periods, and there is only a broad or indirect association between income and expenses, expenses are recognised using systematic and rational allocation procedures. This is often necessary in recognising the expenses associated with the consumption of assets such as property, plant, equipment, goodwill, patents and trademarks, referred to as depreciation or amortisation. These allocation procedures are intended to recognise expenses in the accounting periods in which the economic benefits associated with those items are consumed or expire. [CF.4.51].

An expense is recognised immediately when an expenditure produces no future economic benefits or when, and to the extent that, future economic benefits do not qualify, or cease to qualify, for recognition as an asset. An expense is also recognised in the income statement when a liability is incurred without the recognition of an asset, as when a liability arises under a product warranty. [CF.4.52-53].

2.6.3.G Possible future developments The discussion paper on the Conceptual Framework issued by the IASB in July 2013 (see 1 above) addresses both recognition and derecognition. The IASB acknowledges that any criteria for recognition must have regard to both the relevance of the resulting information to users and the costs of producing that information. For example, internally generated intangible assets are assets of the reporting entity, but the benefits of measuring some such assets may not outweigh the costs of doing so.

The IASB has tentatively concluded that the revised framework should state that the IASB should not require the recognition of an asset or a liability if the IASB concludes that to do so would result in information that it is either irrelevant or not sufficiently reliable to justify the cost of preparing it.

However, in an acknowledgment that the IASB’s judgement on such matters might differ from that of others, the discussion paper clarifies that this general principle could not be used to over-ride a recognition requirement of a particular standard.20

The IASB has also indicated that it will consider the issue of the unit of account to be used in the recognition of assets and liabilities.21 For example, an uncertain tax position might be considered improbable to lead to a cash outflow if considered in isolation. However, that position may be part of an overall tax liability that is virtually certain to lead to an outflow. Whether that position is considered in isolation or as a part of a larger whole may significantly affect its recognition, and measurement (see Chapter 30 at 9).

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The discussion of derecognition is framed mostly in terms of transactions involving financial instruments and leases. These are discussed, respectively, in Chapter 49 and Chapter 24.

2.6.4 Measurement of the elements of financial statements Measurement is ‘the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet and income statement’. [CF.4.54].

A number of different measurement bases are employed to different degrees and in varying combinations in financial statements, including: • Historical cost

Assets are recorded at the amount of cash or cash equivalents paid, or the fair value of the consideration given to acquire them, at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.

• 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. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently.

• Realisable (settlement) value Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business.

• Present value Assets are carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business. [CF.4.55].

The most commonly adopted measurement basis is historical cost, usually combined with other measurement bases. For example, under IFRS inventories are usually carried at the lower of cost and net realisable value (see Chapter 22), marketable securities at market value (see Chapter 47), and pension liabilities are carried at their present value (see Chapter 32). Furthermore, some entities use the current cost basis as a response to the inability of the historical cost accounting model to deal with the effects of changing prices of non-monetary assets. [CF.4.56].

The treatment of measurement in the Conceptual Framework is not altogether satisfactory. As can be seen from the summary above, the discussion essentially describes various practices, without any conceptual analysis of the relative strengths and weaknesses of each method.

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The description of the historical cost model might surprise some by its reference to the cost of an item acquired for non-cash consideration being the ‘fair value of the consideration at the time of acquisition’. That implies that, when a non-cash asset is exchanged for another, a gain should be recognised for any excess at the time of exchange of the fair value of the asset exchanged over its historical cost. Many proponents of the historical cost model would argue that no such gain should be recognised, and that the newly acquired second asset should be measured at the historical cost of the asset given up in exchange for it.

It is also curious that fair value is not one of the four bases for measurement in the Conceptual Framework, in spite of its frequent use in the IASB’s standards. IFRS 13 – Fair Value Measurement – defines fair value as ‘the price that would be received to sell an asset or to transfer a liability in an orderly transaction between market participants at the measurement date’ – see Chapter 14. This essentially means that the term fair value has been adopted to mean essentially what the Conceptual Framework refers to as realisable value.

2.6.4.A Possible future developments The discussion paper on the Conceptual Framework issued by the IASB in July 2013 (see 1 above) acknowledges that the discussion of measurement in the current framework is inadequate.

The IASB proposes that the current mixed measurement model should continue, on the argument that no single measurement model will provide useful information. For example, the IASB argues, most users would regard the fair value of a derivative financial instrument as more useful that its historical cost, but would regard the historical cost of an originated loan or an item of PP&E as more useful than its fair value. However, the IASB intends to keep the number of different measurement models used to a minimum. Unnecessary measurement changes should be avoided and necessary measurement changes should be explained. The cost of any measurement model in relation to its benefit would also be considered.

Perhaps most interestingly, the IASB indicates that its choice of measurement model will be influenced by the impact of a particular model on both the statement of financial position and profit or loss and other comprehensive income. This might be seen as a response to the views of those who have sought to attribute some of the blame for the financial crisis to IFRS and, in particular, the axiom of the current framework that net income is simply the difference between the statements of financial position at the beginning and end of the period, (excluding equity transactions).22

The IASB has also indicated that it will consider the issue of the unit of account to be used in the measurement of assets and liabilities. For example, the value of a large number (n) of equity shares in an entity may be lower than n multiplied by the quoted price for a single share.23

2.6.5 Concepts of capital and capital maintenance The concept of capital maintenance is concerned with how an entity defines the capital that it seeks to maintain. It is a prerequisite for distinguishing between an entity’s return on capital (i.e. profit) and its return of capital. In general terms, an

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entity has maintained its capital if it has as much capital at the end of the period as it had at the beginning of the period. Any amount over and above that required to maintain the capital at the beginning of the period is profit. [CF.4.60, 62].

The Conceptual Framework identifies two broad concepts of capital maintenance: • financial capital maintenance (see 2.6.5.A below); and • physical capital maintenance (see 2.6.5.B below).

The principal difference between the two concepts of capital maintenance is the treatment of the effects of changes in the prices of assets and liabilities of the entity [CF.4.62]. The selection of the appropriate concept of capital by an entity should be based on the needs of the users of its financial statements. [CF.4.58].

The concept of capital maintenance chosen by an entity will determine the accounting model used in the preparation of its financial statements. Most entities adopt a financial concept of capital. Different accounting models exhibit different degrees of relevance and reliability, and it is for management to seek a balance between relevance and reliability (see 2.5.1 above). The Conceptual Framework notes that the IASB does not prescribe a particular model other than in exceptional circumstances, such as in a hyperinflationary economy (see Chapter 16). This intention will, however, be reviewed in the light of world developments. [CF.4.57, 65].

2.6.5.A Financial capital maintenance Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity. Under this concept a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. [CF.4.57, 59(a)].

Financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power. [CF.59(a)]. The financial capital maintenance concept does not require a particular measurement basis to be used. Rather, the basis selected depends upon the type of financial capital that the entity is seeking to maintain. [CF4.61].

Where capital is defined in terms of nominal monetary units, profit represents the increase in nominal money capital over the period. This has the implication that increases in the prices of assets held over the period, conventionally referred to as holding gains, are conceptually profits. They may not be recognised as such, however, until the assets are disposed of in an exchange transaction. [CF.4.63].

When the concept of financial capital maintenance is defined in terms of constant purchasing power units, profit represents the increase in invested purchasing power over the period. Thus, only that part of the increase in the prices of assets that exceeds the increase in the general level of prices is regarded as profit. The rest of the increase is treated as a capital maintenance adjustment and, hence, as part of equity. [CF.4.63].

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2.6.5.B Physical capital maintenance Under this concept a profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. [CF4.59(b)]. The physical capital maintenance concept requires the current cost basis of measurement to be adopted. [CF4.61].

Because capital is defined in terms of the physical productive capacity, profit represents the increase in that capital over the period. Price changes affecting the assets and liabilities of the entity are changes in the physical productive capacity of the entity, which are therefore treated as capital maintenance adjustments within equity and not as profit. [CF4.64].

2.6.5.C Possible future developments In the discussion paper on the Conceptual Framework issued in July 2013 (see 1 above), the IASB has indicated that it does not intend to change the discussion of capital maintenance concepts in the current framework until a new or revised standard on high inflation indicates a need for change.24

2.7 Management commentary Over a number of years, a number of individual countries have issued regulations or guidance requiring or encouraging the preparation of narrative ‘management commentary’ to accompany the financial statements.

In December 2010 the IASB published its first guidance on management commentary – Management Commentary – A Framework for Presentation – as a non-binding ‘IFRS Practice Statement’. The introduction to the Practice Statement clarifies that it is neither an IFRS nor part of the Conceptual Framework. However, it has been prepared on the basis that management commentary meets the definition of other financial reporting in the Preface to International Financial Reporting Standards, and is therefore within the scope of the Conceptual Framework. Consequently, the Statement should be read ‘in the context of’ the Conceptual Framework. [MC.IN2, IN4].

Management commentary is described as a narrative report that relates to financial statements that have been prepared in accordance with IFRSs. Management commentary provides users with historical explanations of the amounts presented in the financial statements, specifically the entity’s financial position, financial performance and cash flows. It also provides commentary on an entity’s prospects and other information not presented in the financial statements. Management commentary also serves as a basis for understanding management’s objectives and its strategies for achieving those objectives. [MC Appendix]. For many entities, management commentary is already an important element of their communication with the capital markets, supplementing as well as complementing the financial statements. [MC.IN3].

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The Practice Statement is intended to set out a broad framework for the preparation of management commentaries, to be applied by management of individual reporting entities to their own specific circumstances. [MC.IN5]. However, the IASB believes that that all management commentary should: • provide management’s view of the entity’s performance, position and progress; and • supplement and complement information presented in the financial

statements. [MC.12].

Management commentary should include information that is forward-looking and has the qualitative characteristics referred to in the Conceptual Framework. [MC.13].

The IASB also envisages that any management commentary will include the following elements: • the nature of the business; • management’s objectives and strategies for meeting those objectives; • the entity’s most significant resources, risks and relationships; • the results of operations and prospects; and • the critical performance measures and indicators that management uses to

evaluate the entity’s performance against stated objectives. [MC.24].

3 POSSIBLE FUTURE DEVELOPMENTS As noted at 1 above, in July 2013 the IASB issued a discussion paper on the Conceptual Framework. The IASB intends to publish an exposure draft of a revised framework in the first quarter of 2015. Various proposals in the discussion paper have been referred to in the discussion above of the areas to which they relate.

In addition, the discussion paper touches on the following more general or pervasive issues.

3.1 Presentation and disclosure The current Conceptual Framework contains no guidance on presentation and disclosure. The discussion paper proposes some guidance that might be included in a revised framework to assist the IASB in developing presentation and disclosure requirements in new or revised IFRSs.25 These proposals are discussed in more detail in Chapter 3 at 6.2.

3.2 Role of the business model in determining an accounting treatment The accounting treatment of a number of items in financial statements currently depends to some extent on the entity’s business model. For example: • a motor vehicle is accounted for as inventory by the manufacturer or dealer but

as PP&E by the purchaser; or • a forward contract for the purchase of foreign currency may be accounted for

differently depending on whether or not the entity regards it as hedging another transaction.

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The IASB has tentatively concluded that financial statements are more relevant if the IASB considers the business model when developing or revising standards.26

4 CONCLUSION Progress on the revised conceptual framework has been slow, made understandably slower by the need for the IASB to focus on the ongoing financial crisis and more recently on major projects such as revenue, leasing and consolidation. This lack of progress is not only somewhat frustrating for those, like ourselves, who believe that a conceptually strong framework is essential for an effective standard-setting process but also, and perhaps more damagingly for the project in the long run, reinforces the scepticism of those who question whether it is really necessary.

We therefore welcome the IASB’s re-activation of the project, albeit now as an IASB project rather than as a joint project with the FASB.

References 1 W. A. Paton and A. C. Littleton, An

Introduction to Corporate Accounting Standards, Monograph No. 3, American Accounting Association, 1940.

2 See, for example: American Accounting Association, Executive Committee, ‘A Tentative Statement of Accounting Principles Affecting Corporate Reports’, Accounting Review, June 1936, pp. 187-191; American Accounting Association, Executive Committee, ‘Accounting Principles Underlying Corporate Financial Statements’, Accounting Review, June 1941, pp. 133-139; American Accounting Association, Committee to Prepare a Statement of Basic Accounting Theory, A Statement of Basic Accounting Theory, 1966; American Accounting Association, Committee on Concepts and Standards for External Financial Reports, Statement on Accounting Theory and Theory Acceptance, 1977. The 1977 report concluded that closure on the debate was not feasible, which is perhaps indicative of the complexity of the problem.

3 Discussion Paper – A Review of the Conceptual Framework for Financial Reporting, IASB, July 2013, (‘DP’), para. 1.5.

4 DP, Section 9. 5 DP, paras 1.26 – 1.29. 6 DP, Appendix B. 7 ED/2010/2 – Conceptual Framework for

Financial Reporting – The Reporting Entity (‘Reporting Entity ED’), IASB, March 2010, para. RE 3.

8 Reporting Entity ED, para. RE 5. 9 Reporting Entity ED, para. RE 6. 10 Reporting Entity ED, para. RE 12. 11 Reporting Entity ED, para. RE 11. 12 IASB Update, November 2010. 13 DP, Section 9. 14 DP, Section 2. 15 DP, Section 3. 16 DP, Section 2. 17 DP, Section 3. 18 DP, paras. 3.45-3.47. 19 DP, Section 5. 20 DP, Section 4. 21 DP, Section 9. 22 DP, Section 6. 23 DP, Section 9. 24 DP, Section 9. 25 DP, Section 7. 26 DP, Section 9.

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