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Conceptual Framework

University of Economics, Prague Faculty of Finance and Accounting

Department of Financial Accounting and Auditing

Regulatory and Conceptual Frameworks for Financial Reporting 1FU496 Intermediate Accounting (MiFA course)

David Procházka


Agenda

Background of the IFRS Adoption

Regulatory framework vs conceptual framework for financial reporting

Regulatory framework in the EU

The IASB’s Conceptual Framework for Financial Reporting

Recommended issues for the final exam


1 Background of the IFRS Adoption

Globalisation of capital markets pushes for harmonised accounting to reduce information risk of foreign investors (optimising returns vs risks)

International accounting harmonisation is running through worldwide adoption of IFRS

Wide range of economic effects of the IFRS adoption, both on individual (company) and country level

Benefits and costs are not spread evenly because of differences in environment surrounding financial reporting (social, political, economic and business factors), legal regime, and quality of enforcement of accounting standards


Regularory framework

Regulatory system

Regulatory bodies

Standard setting

Conceptual framework

Users and objectives

Qualitative characteristics

Fundamental:relevancefaithfull represantation

Enhancing:comparability, verifiabilitytimeliness, understandability

Elements and recognition

Elements:aseet, liability, equityincome, expense

Recognition:definitionprobability/measurement

Measurement and capital

maintenance

Historical costsCurrent costsSettlement valuePresent value

Financial capitalReal capital Physical capital


2 Regulatory framework vs conceptual framework for financial reporting 2.1 Regulatory framework

Necessary to ensure that users of financial statements receive a minimum amount of information that will enable them to make economic decisions regarding their interest in a reporting entity

Lowers contracting costs

Usually establishes the goal of (reasons for) mandatory financial reporting by companies and general requirements on their financial statements as well as punishments for the non-compliance with the regulation


2.2 Conceptual framework (CF)

CF is a coherent system of interrelated objectives and fundamental principles

CF defines the nature, function and limits of financial accounting and financial statements

CF outlines the main ideas, on which the process of preparation of financial statements is based in order to provide users with information useful for their decision making

Does a conceptual framework prescribe particular accounting treatments (such as depreciation methods, etc.)?

Why CF is so important:

- it enables accounting standards to be developed in accordance with generally agreed principles

- it avoids accounting standards to be developed in a piecemeal way in response to specific problems or abuses, which may lead to inconsistencies between different accounting standards, and between accounting standards and legislation

- lack of CF may cause that certain critical issues are not addressed (e.g. Czech accounting does not contain definitions of accounting elements, such as assets and


liabilities, which results in inappropriate treatment of finance leases)

- it helps preparers and auditors of accounts to deal with transactions which are not the subject of a specific accounting standard

- accounting standards based on general principles can be breached harder

- CF strengthens the credibility of financial reporting and the accounting profession

- Existent CF mitigates the possibility to influence the standard-setting process by lobbying parties

Reality:

- CF sets up principles, which are generally accepted and believed to last “for ages”

- however, as transactions become more complex and businesses become more sophisticated, some of principles (definitions, etc.) become old-fashioned

- accounting treatments in new standards start to contradict CF

- if a number of inconsistencies between standards and CF is high, the need for revision of CF is more striking


- standard setters face to an issue, whether to stop their work on standards and to update CF, or whether to do both things simultaneously

- it sometimes ends up with half-solutions (e.g. current IASB’s framework), which creates severe problems (e.g. during the projects on revenue recognition and leases)


3 Regulatory framework in the EU

Regulatory framework is driven by:

- EU directives and regulations

- national company and/or accounting law or generally accepted principles

- security exchange rules

Milestones in IFRS adoption by EU:

- 2000: “EU Financial Reporting Strategy: the way forward”

- 2002: “Regulation (EC) 1606/2002 on International Accounting Standards”

- 2005: The first period of mandatory IFRS adoption by EU listed companies


3.1 Regulation (EC) 1606/2002:

Mandates listed companies to prepare IFRS consolidated financial statements

Allows countries to broaden the scope to other companies/financial statements

Compulsory application (Article 4) => Consolidated accounts of publicly traded companies:

- For each financial year starting on or after 1 January 2005, companies governed by the law of a Member State shall prepare their consolidated accounts in conformity with the international accounting standards if, at their balance sheet date, their securities are admitted to trading on a regulated market of any Member State

Voluntary application (Article 5) => Member States may permit or require:

- the companies referred to in Article 4 to prepare their annual accounts

- companies other than those referred to in Article 4 to prepare their consolidated accounts and/or their annual accounts

The approaches to Article 5 differ significantly across EU countries


3.2 IFRS Adoption in the Czech Republic Regulation until 2010

Mandatory application of the IFRS in:

- consolidated financial statements of companies listed on EU capital markets (see Regulation)

- individual financial statements of those publicly traded companies

Voluntary application of the IFRS in:

- consolidated financial statements of non-listed companies

Regulation from 2011


- consolidated financial statements of companies listed on EU capital markets (see Regulation)

- individual financial statements of those publicly traded companies



- consolidated financial statements of non-listed companies

- individual financial statements of non-listed companies, which are subject of IFRS consolidation

3.3 IFRS Adoption in the Slovak Republic


- all consolidated financial statements, i.e. both listed companies (as required by the Regulation) and private companies, if they are required to consolidate

- individual financial statements of particular companies in selected industries (esp. financial institutions)

- individual financial statements of “big” companies meeting at least 2 out of 3 criteria (total assets and turnover more than 165,969,594.4 €; more than 2,000 employees)


- individual statements of listed companies not covered by mandatory application


3.4 The IFRS Adoption Index

Index measuring the differences in the extent of IFRS adoption in cross-country settings

Based on the analysis of regulatory frameworks in each country => a tool measuring de jure accounting harmonisation

8 area, in which the IFRS may be utilised

Consolidated financial statements:

- public companies

- private companies

Annual accounts:

- public companies

- private companies

- …

Taxation


Tab. 1: Construction of the IFRS Adoption Index

No. Areas of the IFRS adoption Required

or permitted

Not permitted

I Consolidated fin. statements of a consolidating listed company 1 0 II Annual accounts of a consolidating listed company 1 0 III Consolidated statements of a consolidating unlisted company 1 0 IV Annual accounts of a consolidating unlisted company 1 0 V Annual accounts of a consolidated unlisted company 1 0 VI Annual accounts of a non-consolidated unlisted company 1 0 VII Financial statements of entities in certain industries 1 0 VIII Taxation 1 0


Tab. 2: The IFRS Adoption Index for EU states (as at 31 December 2013)

EU State I II III IV V VI VII VIII IndexAustria 1 0 0 0 0 0 0 0 1Belgium 1 0 1 0 0 0 1 0 3Bulgaria 1 1 1 1 1 1 1 0 7Cyprus 1 1 1 1 1 1 1 1 8Czech Republic 1 1 1 1 1 0 0 0 5Denmark 1 1 1 1 1 1 1 1 8Estonia 1 1 1 1 1 1 1 1 8Finland 1 1 1 1 1 1 1 0 7France 1 0 1 0 0 0 0 0 2Germany* 1 0 1 1 1 0 1 1 5*Greece 1 1 1 1 1 1 1 0 7Hungary 1 0 1 0 0 0 0 0 2Ireland 1 1 1 1 1 1 1 1 8Italy 1 1 1 1 0 0 1 1 6Latvia 1 1 1 0 0 0 1 0 4


EU State I II III IV V VI VII VIII IndexLithuania 1 1 1 1 1 1 1 0 7Luxembourg 1 1 1 1 1 1 1 1 8Malta 1 1 1 1 1 1 1 1 8Netherlands 1 1 1 1 1 1 1 1 8Poland 1 1 1 1 1 0 1 1 7Portugal 1 1 1 1 1 0 0 0 5Romania 1 1 0 0 1 0 0 0 3Slovakia 1 1 1 0 0 0 1 1 5Slovenia 1 1 1 1 1 1 1 0 7Spain 1 0 1 0 0 0 0 0 2Sweden 1 0 1 0 0 0 1 0 3United Kingdom 1 1 1 1 1 0 0 1 6

Different patterns on the Regulation (EC) option:

- e.g. Austria does not apply the option at all

- e.g. Denmark, Netherlands, Estonia have adopted IFRS for all companies


4 The IASB’s Conceptual Framework for Financial Reporting 4.1 The structure of the old Framework (1989)

Preface

Introduction

- Purpose and status

- Scope

- Users and their information needs

The objective of financial statements

- Financial position, performance and changes in financial position

Underlying assumptions

- Accrual basis

- Going concern


Qualitative characteristics of financial statements

- Understandability

- Relevance (materiality)

- Reliability (faithful representation, substance over form, neutrality, prudence, completeness)

- Comparability

- Constraints on relevant and reliable information (timeliness, balance between benefit and cost, balance between qualitative characteristics)

- True and fair view/fair presentation

The elements of financial statements

- Financial position (assets, liabilities, equity)

- Performance (income, expenses, capital maintenance adjustments)


Recognition of the elements of financial statements

- the probability of future economic benefit

- reliability of measurement

Measurement of the elements of financial statements

Concepts of capital and capital maintenance


4.2 The structure of the new Framework (2010)

Introduction

- Purpose and status

- Scope

Chapters

- The objective of general purpose financial reporting OB1

- The reporting entity (to be added)

- Qualitative characteristics of useful financial information QC1

- The Framework (1989): the remaining text


4.3 The objective of general purpose financial reporting

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

The users’ decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit

General purpose financial reports are directed to the “primary users”, who cannot 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

General purpose financial reports do not and cannot provide all of the information that users need

General purpose financial reports are not designed to show the value of a reporting entity


4.4 Underlying assumptions

Going concern:

- the financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future

- 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

Accrual basis:

- the effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate

- informs not only of past transactions involving the payment and receipt of cash but also of obligations to pay cash and of resources representing cash to be received in future

- in the new CF this assumption is transferred to the “Objectives”


4.5 Qualitative characteristic of accounting information

Fundamental qualitative characteristics

- relevance

- faithful representation

Enhancing qualitative characteristics

- comparability

- verifiability

- timeliness

- understandability

Relevance:

Relevant information:

- has the ability to influence the economic decisions of users, and

- is provided in time to influence those decisions


Relevant information has predictive and/or confirmatory value

- predictive value enables users to evaluate or assess past, present or future events

- confirmatory value helps users to confirm or correct past evaluations and assessments

Materiality is an entity specific aspect of relevance:

- information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements

- depends on the size of the item or error judged in the particular circumstances of its omission or misstatement

- is a threshold that needs to be studied before considering the other qualities of that information

- if any information does not pass the test of the threshold quality, it is not material and does not need to be considered further

Faithful representation:

To represent faithfully the transactions and other events that it purports to represent in


financial statements, transaction must be accounted for and presented in accordance with their substance and economic reality and not merely their legal form

To be a perfectly faithful representation, financial information has to be:

- complete (must contain all the necessary descriptions and explanations)

- neutral/free from bias (financial statements are not neutral if, by the selection or presentation of information, they influence the making of a decision or judgement in order to achieve a predetermined result or outcome)

- free from error (within the bounds of materiality; however, it does not mean perfectly accurate in all respects)

01-E01; 01-E02


4.6 Elements of financial statements

Elements of financial statements are basic “items”, which are presented to users on the face of financial statements

Elements should inform on an entity’s economic resources and claims (financial position) and changes in them (financial performance measured both on accrual and cash basis)

Assets are:

- resources controlled by the entity

- as a result of past events

- from which future economic benefits are expected to flow to the entity

Liabilities are:

- an entity’s present obligations

- to transfer economic benefits

- as a result of past transactions or events


Equity is:

- the residual interest in the assets of the entity after deducting all its liabilities

Income is:

- an increase in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases in liabilities

- transactions that result in increases in equity, other than those relating to contributions from equity participants

Expense is:

- an decrease in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities

- transactions that result in decreases in equity, other than those relating to distributions to equity participants


4.7 Recognition of the elements of financial statements

Recognition is the process of incorporating in financial statements an item that meets the definition of an element and satisfies the criteria for recognition

It involves the depiction of the item in words and by a monetary amount and the inclusion of that amount in the financial statements totals

The failure to recognise such items cannot be compensated by disclosure of the accounting policies used nor by notes or explanatory material

Recognition criteria:

- it is probable that any future economic benefit associated with the item will flow to or from the entity; and

- the item has a cost or value that can be measured with reliability

The recognition of assets and liabilities falls into three stages:

- initial recognition (e.g. the purchase of a noncurrent asset)

- subsequent remeasurement (e.g. revaluation of the above asset)


- derecognition (e.g. sale of the asset)

Derecognition occurs if:

- an event occurs that eliminates a previously recognised asset or liability

- there is no longer sufficient evidence to support continued recognition


4.8 Measurement of the elements of financial statements 4.8.1 Framework guidance

Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in financial statements

It requires selection of particular basis of measurement

The Framework identifies four possible measurement bases

Historical cost:

- assets are recorded at the amount of cash or cash equivalents paid to acquire them

- liabilities are recorded at the proceeds received in exchange for the obligation, or at the amounts expected to be paid to satisfy the liability

Current cost:

- assets are carried at their current purchase price

- liabilities are carried at the undiscounted amount currently required to settle them


However, the Framework does not solve what kind of current cost to use

Replacement cost-used Replacement cost-new Reproduction cost


Realisable (settlement) value:

- assets are carried at the amount that could currently be obtained by an orderly disposal

- liabilities are carried at their settlement values – the amount to be paid to satisfy them 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 expected cash outflows necessary to settle them

4.8.2 IFRS 13 Fair value measurements

Fair value is not defined by Framework, but quite extensively used by standards on:

- initial recognition (e.g. IFRS 3 measurement of assets and liabilities acquired by business combinations)

- regular basis (e.g. IAS 40 investment property, IAS 39/IFRS 9 financial instruments)


- specific cases (e.g. IFRS 5 assets held for sale)

Each standard contained own definition of fair value => inconsistencies in application across different transactions

IFRS 13 provides a single source of guidance for fair value measurement where it is required by a standard, rather than it being spread throughout several standards

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date

Principles for the determination of FV:

- an individual asset or liability or a group of assets and liabilities depending upon exactly what is required to be measured

- price at which an orderly transaction between willing market participants would take place under current market conditions (no fire sales, etc.)

- take into account the assumptions of market participants, who will generally want to maximise their own best interests

- derived from the principal market, which is the market in which the transaction would


normally take place, if not available then the most advantageous market should be used

- FV is not adjusted for transaction costs because these are specific to the transaction and not a characteristic of the asset or liability; however transaction costs may be used to determine the most advantageous market

Fair value hierarchy:

- Level 1 inputs: comprise quoted prices (“observable”) in active markets for identical assets and liabilities at the measurement date

- Level 2 inputs are observable inputs, other than those included within Level 1 above, which are observable directly or indirectly (similar items adjusted at some degree; if major adjustments, then it may fall into Level 3)

- Level 3 inputs are unobservable inputs for an asset or liability, based upon the best information available, including information that may be reasonably available relating to market participants


4.9 Capital maintenance

Financial capital

Nominal

Profit after nominal amount of money invested is maintained

Real

Profit after purchase power of money invested is maintained

Physical capital

Nominal

Profit after production ability is maintained

Real

Profit after production ability and purchase power is maintained


Selected measurement basis has influence on the usefulness and content of earnings and the equity

Accounting measurement is assigning of monetary values to accounting elements

- the unit of measurement (i.e. money) is not a stable measurement standard

- the market prices of individual assets are changing

The concept of capital maintenance is concerned with how an entity defines the capital that it seeks to maintain:

- it provides the linkage between the concepts of capital and the concepts of profit because it provides the point of reference by which profit is measured

- it is a prerequisite for distinguishing between an entity’s return on capital and its return of capital

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 a physical concept of capital (such as operating capability) capital is regarded as the productive capacity of the entity based on, for example, units of output per day


The selection of the appropriate concept of capital by an entity should be based on the needs of the users of its financial statements:

- under financial capital maintenance, 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; financial capital maintenance can be measured in either nominal monetary units or units of constant purchasing power

- under physical capital maintenance, 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

IFRSs adopt financial concept with some provisions for individual price changes (usage of fair value) or hyperinflation (IAS 29)


Fig. 1 Unstable monetary unit

01-E03; 01-E04; 01-E05; 01-E06


5 Recommended issues for the final exam

Covered by this Presentation

- explain the difference between a regulatory framework for financial reporting and a conceptual framework for financial reporting

- explain the difference between accounting standards and conceptual framework

- describe main features of a principles-based and a rules-based framework

- summarise the relationship between national standard setters and the IASB in respect of the standard-setting process

- describe the main tenets of the IASB’s Conceptual Framework

- define and discuss fundamental and enhancing qualitative characteristics of accounting information

- define and explain the process of recognition of elements in financial statements

Not covered by this Presentation, but relevant for the topic

- sketch the main differences between principles-based and rules-based financial


reporting

- describe the IASB’s standard-setting process including revisions to and interpretations of standards (so called Due Process)

- outline and discuss the advantages and disadvantages of international harmonisation of financial reporting

- explain, what is meant by the terms “(IFRS) endorsement” and “(IFRS) enforcement”

- assess the advantages and disadvantages of each measurement basis (incl. FV) from the point of investors, creditors, and managers


David Procházka Department of Financial Accounting and Auditing

Faculty of Finance and Accounting University of Economics, Prague

W. Churchill Sq. 4 Prague, 130 67 Czech Republic

Web: https://webhosting.vse.cz/prochazd Email: <[email protected]>

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