Farr Study Guide Seventh Edition 1 120 PDF

FOUNDATION EXAM
FINANCIAL ACCOUNTING
AND REPORTING
STUDY GUIDE
Foundation exam
Financial Accounting
and Reporting
ii
Seventh edition 2017

First edition 2010
The publishers are grateful to the IASB for permission to
reproduce extracts from the International Financial
ISBN 9781 5097 0301 2
Reporting Standards including all International Accounting
Standards, SIC and IFRIC Interpretations (the Standards). Previous ISBN 9781 4727 3881 3
The Standards together with their accompanying
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FINANCIAL ACCOUNTING AND REPORTING | iii
FOUNDATION EXAMS
International Education Standards

CPA Australia is a member of the International Federation of Accountants (IFAC). All foundation exam
education materials are developed in line with IFAC's International Education Standards. These
standards provide guidance in establishing the content of professional accounting education
programs together with the associated assessment. The standards also assist in developing the
required passing standard for accounting education and competence of a professional accountant.
The foundation exams provide you with the opportunity to demonstrate your competence in areas
required for Associate membership of CPA Australia. By demonstrating this entry level knowledge you
will be well positioned to succeed at the CPA Program and ultimately attaining the CPA designation.
YOU AND YOUR STUDY PLAN
This Study Guide is designed to give you an understanding of what to expect in your exam as well as
covering the fundamentals that you need to know. Exams will be based on the contents of the current
Study Guide. You will need to check My Online Learning to confirm which version you should use
based on your exam date.
There are no specifically recommended hours of study. Each candidate brings their own level of
experience and knowledge to the foundation exams. The number of study hours required is entirely
dependent on your prior knowledge of the subject. You will need to develop your own study plan.
Refer to Preparing for foundation exams on page viii.
ADDITIONAL LEARNING SUPPORT
If you feel you have gaps in your knowledge after reviewing the Study Guide, there is a range of
optional additional support to assist in your exam preparation. Additional learning support caters for
different learning styles and budgets.
Please check the CPA Australia website for more information www.cpaaustralia.com.au/learningsupport
STANDARDS AND LEGISLATION
The material in this Study Guide has been prepared based upon standards and legislation in effect as
at 1 January 2017. Candidates are advised that they should confirm effective dates of standards and
legislation when using additional study resources. Exams are based on the learning objectives
outlined within this Study Guide.
iv | INTRODUCTION
CONTENTS
Page
INTRODUCTION
Foundation exams iii
Module features v
Preparing for your foundation exam vii
Module summary ix
Learning objectives xi
MODULE
1 The financial reporting environment 1
2 The accounting theory 97
3 Financial statements 147
4 Application of specific accounting standards 195
5 Business combinations 265
6 Analysis of financial statements 349
Revision questions 387
Answers to revision questions 411
Before you begin questions: Answers and commentary 425
Glossary of terms 443
Formulae 453
Index 457
FINANCIAL ACCOUNTING AND REPORTING | v
MODULE FEATURES
Each module contains a number of helpful features to guide you through each topic.
Learning Show the referenced CPA Australia learning objectives.

objectives
Topic list Tells you what you will be studying in this module.
Introduction Presents a general idea of what is covered in this module.
Module summary Summarises the content of the module, helping to set the scene so that you
diagram can understand the bigger picture.
Before you begin This is a small bank of questions to test any pre-existing knowledge that you
may have of the module content. If you get them all correct then you may
be able to reduce the time you need to spend on the particular module.
There is a commentary section at the end of the Study Guide called Before
you begin: Answers and commentary.
Section overview This summarises the key content of the particular section that you are about
to start.
Learning objective This box indicates the learning objective covered by the section or
reference paragraph to which it relates.
LO
1.2
Definition Definitions of important concepts. You really need to know and understand
these before the exam.
Exam comments These highlight points that are likely to be particularly important or relevant
to the exam. (Please note that this feature does not apply in every
exam
foundation exam Study Guide.)
Worked example This is an illustration of a particular technique or concept with a solution or

explanation provided.
Question This is a question that enables you to practise a technique or test your
understanding. You will find the solution at the end of the module.
Checkpoint Review the key areas covered in the module.

vi | INTRODUCTION
Quick revision A quick test of your knowledge of the main topics in this module.
questions The quick revision questions are not a representation of the difficulty or
style of questions which will be in the exam. They provide you with an
opportunity to revise and assess your knowledge of the key concepts
covered in the materials so far. They are not a practice exam, but rather a
means to reflect on key concepts and not as the sole revision for the exam.
Revision The revision questions are not a representation of the difficulty or style of
questions questions which will be in the exam. They provide you with an opportunity
to revise and assess your knowledge of the key concepts covered in the
materials so far. They are not a practice exam, but rather a means to reflect
on key concepts and not as the sole revision for the exam.
Case study This is a practical example or illustration, usually involving a real world
scenario.
Formula to learn These are formulae or equations that you need to learn as you may need to
apply them in the exam.
Bold text Throughout the Study Guide you will see that some of the text is in bold
type. This is to add emphasis and to help you to grasp the key elements
within a sentence and paragraph.
FINANCIAL ACCOUNTING AND REPORTING | vii
PREPARING FOR YOUR FOUNDATION EXAM
STUDY PLAN
 Review all the learning objectives thoroughly. Use the topic exam weightings listed at the end of
the learning objectives to develop a study plan to ensure you provide yourself with enough time to
revise each learning objective.
 Don't leave your study to the last minute. You may need more time to explore learning objectives
in greater detail than initially expected.
 Be confident that you understand each learning objective. If you find that you are still unsure after
reading the Study Guide, seek additional information from other resources such as text books,
supplementary learning materials or tuition providers.
STUDY TECHNIQUES
 In addition to being able to complete the revision and self-assessment questions in the Study
Guide, ensure you can apply the concepts of the learning objectives rather than just memorising
responses.
 Some exams have formulae and discount tables available to candidates throughout the exams. My
Online Learning lists the tools available for each exam.
 Check My Online Learning on a weekly basis to keep track of announcements or updates to the
Study Guide.
TIPS FOR EXAMS

 Plan to arrive at the exam centre at least 15 minutes before your exam. Allow for possible delays
with public transport or traffic.
 You have three hours and fifteen minutes to complete the exam. As soon as you commence the
exam your exam clock in the top right hand corner of the screen begins to count down. Watch your
time carefully.
ANSWERING MULTIPLE CHOICE QUESTIONS

Foundation exams are a series of 100 multiple choice questions. Each question will contain four
possible options.
Step 1 Attempt every question. Read the question thoroughly. You may prefer to work out the
answer before looking at the options, or you may prefer to look at the options at the
beginning. Adopt the method that works best for you.
Step 2 Read the four options and see if one matches your own answer. Be careful with numerical
questions, as some options are designed to match answers that incorporate common
errors. Check that your calculation is correct. Have you followed the requirement exactly?
Have you included every step of the calculation?
Step 3 You may find that none of the options matches your answer.
 Re-read the question to ensure that you understand it and are answering the
requirement.
 Eliminate any obviously wrong answers.
 Consider which of the remaining answers is the most likely to be correct and select the
option.
viii | INTRODUCTION
Step 4 If you are still unsure, you can flag the question and continue to the next question. Some
questions will take you longer to answer than others. Try to reduce the average time per
question, to allow yourself to revisit problem questions at the end of the exam.
Revisit unanswered questions. A review tool is available at the end of the exam, which
allows you to Review Incomplete or Review Flagged questions. When you come back to
a question after a break you often find you are able to answer it correctly straight away.
You are not penalised for incorrect answers, so never leave a question unanswered!
COMPUTER-BASED EXAM NAVIGATION

Your computer-based exam has the following functions:
 Navigation
– You can select your answer by: clicking on the circle to the left of the option, or typing the letter
corresponding to the option.
– To move through the exam, you use the 'Next' or 'Previous' buttons on the bottom of the
screen. The function of each button is selected by your mouse, or with a combination of
keyboard keys. For example, you can select the 'Next' button by clicking it with the mouse, or
by typing ALT + N.
– The 'Next' button moves you from one screen to the next screen. If you wish to go back and
view the screen you just viewed, click the 'Previous' button or type ALT + P.
– There is also a 'Navigator' button on the bottom of the screen which allows you to click ahead
to any question in the exam. This button can be accessed using your mouse or ALT + V.
'Navigator' allows you to see a list of all questions and their status including
'Incomplete'/'Complete' and 'Unseen'. Any questions you have flagged for review will also be
shown in this view.
 Select for review
– There is a flag in the upper right corner of your exam screen labelled 'Flag for Review'.
Alternatively you can use ALT + F to flag a question. You mark an exam question to review at a
later time by clicking on this flag. The flag will appear filled-in once it is selected. You may mark
any exam question for later review, whether you select an answer or not.
 Review Screen
– After finishing the last exam question, you will see a review screen. This lists every exam
question. If you clicked the 'Flag for Review' flag on a question screen, that question appears on
the Review Screen marked with the flag filled in.
– If you skipped any exam questions, these will be labelled as 'Incomplete' even if you did not
select them for review.
– From the Review Screen you can choose to:
1. review all of the questions in the exam by clicking 'Review All';
2. individually select questions for review (click on the question number) or choose more
questions for review (click on the flags corresponding to the questions);
3. review all questions marked as incomplete by clicking 'Review Incomplete';
4. begin reviewing the selected review questions by clicking 'Review Flagged'; or
5. exit by clicking 'End Review' – this will also end your exam.
FINANCIAL ACCOUNTING AND REPORTING | ix
MODULE SUMMARY
This summary provides a snapshot of each of the modules, to help you to put the syllabus as a whole
and the Study Guide itself into perspective.
Modules 1 and 2 mainly focus on the accounting concepts and principles and theories that are
relevant to financial accounting and reporting. Modules 3, 4 and 5 then cover the actual preparation
and presentation of financial statements for limited liability companies, both single companies and
groups of companies, with module 4 focusing particularly on the application of specific accounting
standards. Finally, module 6 covers the analysis and interpretation of financial statements.
MODULE 1 – THE FINANCIAL REPORTING ENVIRONMENT

In this module we will begin by considering the purpose of financial reporting and in particular who
the financial statements are prepared for – the users of financial statements – and their information
needs. We will also consider the regulatory framework within which international accounting standards
are prepared and how this contributes to international GAAP.
The IASB's Conceptual Framework for Financial Reporting sets out and explains the concepts and
principles on which, in theory, IFRSs are based. We look at the advantages and disadvantages of using
a conceptual framework and also at the objectives of general purpose financial reports: financial
statements prepared for users external to a business.
We also consider accounting policies: the specific principles and conventions that an entity adopts in
preparing and presenting financial statements.
This module also explains the concepts that underlie the preparation of financial statements and the
qualities that financial information must have if it is to be useful to the users of financial statements.
This module ends with a consideration of the elements of financial statements as set out in the IASB's
Conceptual Framework – these are assets, liabilities, equity, income and expenses. You will learn the
recognition criteria for each of these elements.
MODULE 2 – THE ACCOUNTING THEORY

The most common measure of asset/liability valuation is historical cost. However, in this module you
will learn how to identify, explain and calculate other methods of valuation. You will also consider
alternative methods of measuring capital and how this ties in with asset/liability valuation.
In a company the shareholders are the owners, but the company is managed by the directors. The
directors are agents of the shareholders, therefore you will consider what is meant by agency theory.
You will also look at the various types of information within a company's annual report and financial
statements that are available to shareholders and other users. Some of this information helps the
shareholders to assess the performance of the company and of its directors.
MODULE 3 – FINANCIAL STATEMENTS

In this module we begin by looking at the overall format and content of company financial statements
as set out in IAS 1 (revised) Presentation of Financial Statements. The module covers the statement of
profit or loss and other comprehensive income, the statement of financial position and the statement
of cash flows (IAS 7 Statement of Cash Flows).
MODULE 4 – APPLICATION OF SPECIFIC ACCOUNTING

STANDARDS
In this module, we consider in detail the application of specific accounting standards, in particular the
accounting treatment of intangible non-current assets in general and research and development
costs, as well as the accounting treatment in situations where assets (tangible or intangible), fall in
value. The module moves on to the topical areas of revenue recognition and accounting for current
x | INTRODUCTION
tax and deferred tax. It ends with a consideration of foreign currency accounting. There are two main
aspects to dealing with foreign exchange – firstly, many companies will buy or sell goods from or to
another country and in a foreign currency. These transactions in the foreign currency must be
translated before they can be included in the financial records. The second aspect is that groups may
include a foreign subsidiary and before the subsidiary's results can be included in the group financial
statements the subsidiary's own financial statements must be translated.
MODULE 5 – BUSINESS COMBINATIONS

This detailed module will be looking at the techniques for preparing group financial statements or
consolidated financial statements. It begins with a consideration of the major definitions and
principles of consolidation which are vital to your understanding of the subject. Next we will study the
basic procedures for producing a consolidated statement of financial position. Plenty of question
practice is required but if you understand the basic steps and workings at this stage then your further
studies of consolidated financial statements will become much easier. We move on to covering the
preparation of the consolidated statement of profit or loss. This module ends with an examination of
the accounting treatment of associated companies – the equity method of accounting.
MODULE 6 – ANALYSIS OF FINANCIAL STATEMENTS

In this module we consider the interpretation of financial statements by looking at the calculation of a
number of different ratios and more importantly how these ratios can be used to analyse and interpret
the financial statements. We shall also consider the limitations of financial analysis.
FINANCIAL ACCOUNTING AND REPORTING | xi
LEARNING OBJECTIVES
CPA Australia's learning objectives for this Study Guide are set out below. They are cross-referenced
to the module in the Study Guide where they are covered.
FINANCIAL ACCOUNTING AND REPORTING
GENERAL OVERVIEW
This exam covers an understanding of the format and function of financial statements, including
analysis and interpretation of financial statements. It also includes the production of financial
statements for consolidated company groups, and foreign currency translation.
This exam covers a critical awareness of accounting issues in an international context. It requires an
understanding of the theoretical concepts within the regulatory and conceptual framework of
corporate reporting. This includes recognition criteria, methods of valuation, and reporting and
disclosure of the financial performance of companies.
These are the topics that will be covered in the exam.
MODULE (S)
WHERE
Topics COVERED
LO1. The Financial Reporting Environment
LO1.1 Describe the regulatory environment for financial reporting in Australia 1
and the reasons for accounting and reporting requirements
LO1.2 Discuss the main types of business entity and explain the reasons for 1
selecting each structure.
LO1.3 Identify different types of accounting regulation, including laws, 1
Generally Accepted Accounting Principles and International Financial
Reporting Standards.
LO1.4 Explain how the requirements from users, together with social and 1
environmental developments, impact the underlying principles and
requirements of financial reporting and the desire to establish a single
set of international accounting standards.
LO1.5 Describe the role of the International Accounting Standards Board in 1
developing a regulatory framework and explain how new policies and
standards are established.
LO1.6 Identify the purpose of a conceptual framework and the key 1
characteristics in the Generally Accepted Accounting Principles (GAAP)
and apply the knowledge to define and recognise the different
elements of the financial statements.
LO1.7 Describe and demonstrate the role of accounting standards and 1
accounting policies in fairly presenting the financial performance and
financial position of an entity.
xii | INTRODUCTION
MODULE (S)
WHERE
Topics COVERED
LO2. The Accounting Theory
LO2.1 Compare historical cost accounting with other methods of valuation 2
and explain the differences.
LO2.2 Explain agency and contracting theories and how they relate to 2
accounting policy choice (positive accounting theory).
LO2.3 Apply the recognition criteria for the elements of the financial 2
statements according to the conceptual framework (normative theory).
LO3. Financial Statements
LO3.1 Prepare and present the statement of profit or loss and other 3
comprehensive income with appropriate disclosure in accordance with
relevant accounting standards and policies.
LO3.2 Prepare and present the statement of financial position with 3
appropriate disclosure in accordance with relevant accounting
standards and policies.
LO3.3 Prepare and present the statement of cash flows in accordance with 3
relevant accounting standards and policies.
LO3.4 Demonstrate the ability to detect, investigate and correct discrepancies 3
or particular items/events while matching the financial statements to
supporting documentation.
LO4. Application of Specific Accounting Standards
LO4.1 Calculate the carrying amounts of different classes of intangible assets 4
and prepare the relevant journal entries.
LO4.2 Interpret contracts to determine the amount and timing of revenue to 4
be recognised in the financial statements and reconcile the differences
between ledgers if necessary.
LO4.3 Calculate current and deferred income tax and prepare the relevant 4
journal entries to record the tax effect in the financial statements.
LO4.4 Calculate and account for foreign currency transactions at transaction 4
date and subsequent dates
LO4.5 Translate financial statements from a functional currency to a 4
presentation currency
LO5. Business Combinations
LO5.1 Discuss the accounting issues for various forms of business combinations. 5
LO5.2 Explain how goodwill is measured and disclosed at the date of 5
acquisition and prepare the relevant journal entries.
LO5.3 Explain how goodwill is measured and impaired subsequent to 5
acquisition and prepare the relevant journal entries
LO5.4 Discuss the concept of control and calculate the non-controlling 5
interest share of equity.
LO5.5 Prepare consolidated statements of financial position, including the 5
entries for goodwill and non-controlling interests.
FINANCIAL ACCOUNTING AND REPORTING | xiii
MODULE (S)
WHERE
Topics COVERED
LO5.6 Prepare consolidated statements of profit or loss and other 5
comprehensive income, including the entries for non-controlling
interests and intra-group transactions.
LO6. Analysis of Financial Statements
LO6.1 Calculate, analyse and interpret financial ratios and their 6
interrelationship in the financial statements.
LO6.2 Explain the limitations of financial statement analysis. 6
Weighting of learning objectives in exam
1 The Financial Reporting Environment 28%

2 The Accounting Theory 17%
3 Financial Statements 17%
4 Application of Specific Accounting Standards 15%
5 Business Combinations 13%
6 Analysis of Financial Statements 10%
TOTAL 100%
xiv | INTRODUCTION
1
MODULE 1
THE FINANCIAL
REPORTING
ENVIRONMENT
Learning objectives Reference
Describe the regulatory environment for financial reporting in Australia and the reasons LO1.1
for accounting and reporting requirements
Discuss the main types of business entity and explain the reasons for selecting each LO1.2
structure
Identify different types of accounting regulation, including laws, Generally Accepted LO1.3
Accounting Principles and International Financial Reporting Standards
Explain how the requirements from users, together with social and environmental LO1.4
developments, impact the underlying principles and requirements of financial reporting
and the desire to establish a single set of international accounting standards
Describe the role of the International Accounting Standards Board in developing a LO1.5
regulatory framework and explain how new policies and standards are established
Identify the purpose of a conceptual framework and the key characteristics in the LO1.6
Generally Accepted Accounting Principles (GAAP) and apply the knowledge to define
and recognise the different elements of the financial systems
Describe and demonstrate the role of accounting standards and accounting policies in LO1.7
fairly presenting the financial performance and financial position of an entity
Topic list
1 The purpose of accounting

2 Nature, principles and scope of financial reporting
3 The reporting entity
4 Users' and stakeholders' needs
5 The need for a regulatory framework
6 The IFRS Foundation and the IASB
7 Conceptual framework and GAAP
8 The IASB's Conceptual Framework
9 The objective of general purpose financial reporting
10 Accounting regulation
2 | THE FINANCIAL REPORTING ENVIRONMENT
Topic list
11 Future developments
12 Accounting policies
13 IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors
14 The role of accounting standards
15 Accounting standards and choice
16 Accounting concepts
17 Qualitative characteristics of financial information
18 International Financial Reporting Standards
19 Developments in international harmonisation
20 The elements of financial statements
21 Recognition of the elements of financial statements
22 Applying the recognition criteria
23 The main financial statements
FINANCIAL ACCOUNTING AND REPORTING | 3
SUBJECT OUTLINE
This module introduces some basic ideas about the need for financial information and the users of
financial information. It also covers the definition of financial reporting.
MODULE 1
We then move on to look at the different sources of accounting regulation. Accounting is regulated by
local statute (such as company law), by stock exchange requirements and by accounting standards.
We will focus in particular on the activities of the International Accounting Standards Board (IASB)
which is responsible for setting International Financial Reporting Standards (IFRS).
We will discuss the importance of IFRS in the global regulation of accounting and the process the
IASB undertakes in issuing a new accounting standard.
We move on to look at the IASB's Conceptual Framework for Financial Reporting which represents the
theoretical framework upon which all IFRS are based.
We also consider accounting policies: the specific principles and conventions that an entity adopts in
preparing and presenting financial statements. IAS 8 Accounting Policies, Changes in Accounting
Estimates and Errors explains how an entity should select and apply accounting policies.
We examine the role and purpose of accounting standards in the regulation of financial reporting. We
will look at this in the context of accounting policies and achieving the aim of preparing useful
financial information.
We will also review some of the key accounting concepts that have to be considered when preparing
financial statements and discuss the process of harmonisation of accounting standards on a global
basis.
We will examine the main elements of financial statements: assets, liabilities, equity, income and
expenses. Finally, we will look at the financial statements where these items are recognised and
examine the recognition criteria for each of the elements of the financial statements. The module
content is summarised in the diagrams below.
The financial reporting environment
Financial reporting involves

Accounting: process of producing financial statements Need for regulation:
recording, analysing and GAAP is a combination of:
for users
summarising transactions of company law
a business and accounting standards
communicating that stock exchange rules
information to decision IFRSs
makers Users have different needs:
Management
Shareholders
Suppliers Regulation varies
Customers amongst countries
Lenders depending on local context
Reporting entity: and level of development
Authorities
Entity whose general of the nation
Employees
purpose financial
Financial analysts and
statements are relied
advisers
upon by users of
Public
accounts
Benefits of regulation:
Information prepared
consistently
A regulatory framework Companies disclose more
and accounting standards information than they
help make financial statements would if there was no
more useful to users regulation
IASB issues Standards
IASB objectives:
To develop high quality,
understandable and enforceable
global accounting standards
To bring about convergence of
national standards and IFRS
The Conceptual Framework and

accounting policies
Conceptual framework and The IASB's Conceptual Framework for The use of judgment in
GAAP Conceptual framework Financial Reporting is the international accounting decisions:
MODULE 1
is a set of theoretical principles conceptual framework. Accounting standards provide
that form a frame of reference Its purpose is to: guidance on dealing with
for financial reporting
assist with the development of transactions
future accounting standards If no standard exists, the
promote harmonisation accountant must use
assist national standard-setters judgement
Benefits of framework Conceptual framework is a
assist auditors/preparers/users of
Used as a basis for financial statements useful reference point in
development of accounting these situations
standards
Financial reporting based on
standardised principles
Preparers apply the spirit and
reasoning behind standards; Objective of general purpose Accounting policies
therefore harder to avoid financial reporting: Principles, bases, rules,
compliance Provide useful information to conventions and practices
existing and potential investors, used in preparing financial
lenders and other creditors statements
Provide information that is
relevant and faithfully
represents the underlying
transactions
IAS 8 Accounting Policies, Changes

in Accounting Estimates and Errors
Accounting standards and concepts
Role of accounting standards Accounting concepts International harmonisation

Set out accounting rules Going concern (underlying Aim to have one set of global
companies must follow assumption) accounting standards
Applying accounting standards Accruals Number of barriers, but many
should give a fair presentation Substance over form advantages
EU adopted IFRS from 2005
IASB and US FASB have
carried out important joint
Accounting standards and choice projects to harmonise
Standards reduce variations in Fundamental qualitative accounting standards
methods of accounting characteristics of financial
information: relevance and
But may be faithful representation
inflexible/inappropriate in
some circumstances
Enhancing qualitative
characteristics of financial
information: comparability;
verifiability; timeliness; and
understandability
Elements of financial
statements and their
recognition criteria
Elements of financial Recognition criteria The main elements of

statements The Conceptual Framework states financial reports
The Conceptual Framework that an element of the financial The statement of financial
defines: statements is recognised if it: position includes:
assets assets
meets the definition of an
liabilities liabilities
element;
equity equity
is probable that any future
income The statement of profit or
economic benefit associated
expenses loss and other
with the item will flow to or
comprehensive income
from the entity; and
includes:
the item has a cost or value
income
that can be measured with
expenses
reliability
BEFORE YOU BEGIN
If you have studied these topics before, you may wonder whether you need to study this module in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in
the area.
MODULE 1
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the module to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the module you can find the information, and you
will also find a commentary at the back of the Study Guide.
1 Identify three differences between financial and management accounts. (Section 1)
2 What is the purpose of financial reporting? (Section 2)
3 What is a reporting entity? (Section 3)
4 Who are the main user groups of financial statements, and why are they
interested in financial information? (Section 4.2)
5 What is GAAP? (Section 5.2)
6 Which of the following are advantages of accounting regulation?
I increased public confidence in financial statements
II enhanced comparability between financial statements
III the development of rules which are applicable to all entities
IV the disclosure of more useful information than if there were no regulations
A I and IV only
B I, II and IV only
C II, III and IV only
D I, II, III and IV (Section 5.3)
7 What is the IASB and what are its objectives? (Sections 6.1 and 6.3)
8 What is the IFRS Advisory Council and what is its purpose? (Section 6.4)
9 What is the IFRS Interpretations Committee and what is its purpose? (Section 6.4)
10 What is a conceptual framework? (Section 7.1)
11 What are the problems associated with not having a conceptual framework? (Section 7.2)
12 Which of the following are objectives of the IASB's Conceptual Framework?
I to promote consistency between IFRS
II to assist in the development of new IFRS
III to assist auditors in forming their opinion
IV to assist national standard-setters in setting national standards
A I and II only
B III and IV only
C I, II and IV only
D I, II, III and IV (Section 8.2)
13 What is the objective of general purpose financial reporting according to the
IASB's Conceptual Framework? (Section 9)
14 What are accounting policies? (Section 12)
15 How is a change in accounting policy accounted for? (Section 13.3)
16 How is a change in accounting estimate accounted for? (Section 13.4)
17 What is the underlying assumption in preparing financial statements according
to the Conceptual Framework? (Section 16.1)
18 Explain the concept of 'substance over form' and provide an example of

its application. (Section 16.3)
19 What are the two fundamental qualitative characteristics and the four
enhancing qualitative characteristics of financial statements identified by
the Conceptual Framework? (Section 17)
20 What makes financial information relevant? (Section 17.1)
21 Identify three barriers to the global harmonisation of accounting standards. (Section 19.2)
22 Define an asset. (Section 20.2)
23 Define a liability. (Section 20.2)
24 Define equity. (Section 20.2)
25 What criteria must be met in order for an item to be recognised in the financial
statements? (Section 21)
26 Which of the following statements is/are true?
I All assets and liabilities must always be presented in order of liquidity.
II A liability is always classified as non-current where the amount due is to be settled in more than
12 months.
A I only
B II only
C both I and II
D neither I nor II (Sections 23.1.1 & 23.1.2)
1 THE PURPOSE OF ACCOUNTING
Section overview
 Accounting is the process of recording, analysing and summarising transactions of an entity
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and communicating that information to decision makers.
 A business is an entity which exists to make a profit.
 There are three main types of business entity: sole traders, partnerships and limited liability
companies.
 Non-commercial undertakings such as charities, clubs and government entities may also
prepare accounts.
1.1 WHAT IS ACCOUNTING?

You may have a wide understanding of what accounting and financial reporting is. Your job may be in
one area or type of accounting, but you must understand the breadth of work which an accountant
undertakes. In particular, you need to understand the distinction between financial accounting and
management accounting.
Definition
Accounting is the process of recording, analysing and summarising transactions of a business and
communicating that information to decision makers.
Renaissance scholar Luca Pacioli wrote the first printed explanation of double-entry bookkeeping in
1494. Double-entry bookkeeping involves entering every transaction as a debit in one account and a
corresponding credit in another account, and ensuring that they 'balance'. Pacioli's description of the
method was widely influential.
The first English book on the subject was written in 1543 by John Gouge. The practice of double-entry
bookkeeping has barely changed since then and is standard across the world, based upon the
concept that every transaction has a dual effect expressed as debits equals credits.
The original role of the accounting function was to record financial information and this is still its main
focus.
Why do businesses need to produce accounts? If a business is being run efficiently, why should it have
to go through all the bother of accounting procedures in order to produce financial information?
A business needs to produce information about its activities because there are various groups of
people who want or need to know that information. Later in this module we will consider the different
groups of users and the type of information that is of interest to the members of each group.
1.2 FINANCIAL ACCOUNTING

Definition
Financial accounting is a method of reporting the results and financial position of a business.
It is not primarily concerned with providing information towards the more efficient running of the
business. Although financial accounts are of interest to management, their principal function is to
satisfy the information needs of persons not involved in running the business, in particular
shareholders. Financial accounts provide historical information.
1.3 MANAGEMENT ACCOUNTING

The information needs of management go far beyond those of other account users. Managers
have the responsibility of planning and controlling the resources of the business and for making
decisions about the direction of the business both in the longer term and on a day to day basis.
Therefore they need much more detailed information. They also need to plan for the future e.g.
budgets, which predict future revenue and expenditure.
Definition
Management accounting, sometimes known as cost accounting, is a management information

system which analyses data to provide information as a basis for managerial action. The concern of a
management accountant is to present accounting information in the form most helpful to
management.
1.4 WHAT IS A BUSINESS?

Definitions
Businesses of whatever size or nature exist to make a profit.

A business is an integrated set of activities and assets that is capable of being conducted and
managed for the purpose of providing a return in the form of dividends, lower costs or other
economic benefits directly to investors or other owners, members or participants.
There are a number of different ways of looking at a business. Some ideas are listed below.
 A business is a commercial or industrial concern which exists to deal in the manufacture, re-sale
or supply of goods and services.
 A business is an organisation that uses economic resources to create goods or services which
customers will buy.
 A business is an organisation providing jobs for people.
 A business invests money in resources e.g. buildings, machinery, employees, in order to make
even more money for its owners.
This last definition introduces the important idea of profit. Businesses vary from very small businesses
e.g. the local shopkeeper or plumber, to very large ones e.g. IKEA, Nestlé, Unilever. However all of
them want to earn profits.
Definition
Profit is the excess of revenue (income) over expenses. When expenses exceed revenue, the business
is running at a loss.
One of the jobs of an accountant is to measure revenue and expenditure, and so profit.
1.5 TYPES OF BUSINESS ENTITY

LO
1.2 There are three main types of business entity:
 sole traders;
 partnerships; and
 limited liability companies.
Sole traders are people who work for themselves. Examples may include the local shopkeeper, a
plumber and a hairdresser. The term sole trader refers to the ownership of the business – sole traders
can have employees.
Partnerships occur when two or more people decide to run a business together. Examples may
include an accountancy practice, a medical practice and a legal practice.
Limited liability companies are incorporated to take advantage of 'limited liability' for their owners
(shareholders). This means that, unlike sole traders and partners, who are personally responsible for
the amounts owed by their business, the shareholders of a limited liability company are only
responsible for the amount unpaid on their shares. This means that if the shareholders have
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purchased shares costing $100 but have only paid $40 to date, they would have to contribute the
remaining $60 towards paying the company's debts.
Generally, in law sole traders and partnerships are not separate entities from their owners. This is true
in many jurisdictions, for example Australia, the UK, India, New Zealand, China, Japan and Germany.
In the US, however, partnerships do have separate legal personality but the partners are wholly liable
for debts of the partnership. In all cases, however, a limited liability company is legally a separate
entity from its owners and it can issue contracts in the company's name.
For accounting purposes, all three entities are treated as separate from their owners. This is called
the business entity concept. The methods of accounting used in all three types of business entity will
be very similar, although will tend to become more complex the larger the entity.
1.5.1 NON-COMMERCIAL UNDERTAKINGS

It is not only businesses that need to prepare financial statements. Charities and clubs, for example,
may need to prepare financial statements every year. Financial statements also need to be prepared
for government organisations (public sector organisations such as hospitals and local councils).
2 NATURE, PRINCIPLES AND SCOPE OF FINANCIAL

REPORTING
Section overview
 Financial reporting is the process of classifying, recording and presenting financial data in
accordance with generally established concepts and principles.
2.1 WHAT IS FINANCIAL REPORTING?

LO Financial data is the name given to the record of actual transactions carried out by a business e.g.
1.1 sales of goods, purchases of goods, payment of expenses. These transactions are analysed according
to type, recorded in ledger accounts and summarised in the financial statements.
Financial reporting is the process of reporting the results and financial position of a business or
'reporting entity'. Although financial accounts are of interest to management, their principal function
is to provide historical information in order to satisfy the information needs of external users such as
shareholders. Financial accounting is not primarily concerned with providing information towards the
more efficient running of the business – this is the function of a separate branch of accounting, known
as 'management accounting'.
2.2 GENERAL PURPOSE FINANCIAL REPORTING

Accounting Standards (and company law in some countries) prescribe that a company should
produce accounts to be presented to the owners (shareholders). Accounts must normally be
presented at least annually, and there are usually detailed regulations on what they must contain and
the form they must take. For example, in Australia, the form and content of company financial
statements is regulated by the Corporations Act 2001 and by Australian Accounting Standards, which
are equivalent to International Financial Reporting Standards (IFRS) issued by the International
Accounting Standards Board (IASB).
Large listed companies (sometimes known as public companies) are required to publish their annual
financial statements. A listed company is a company whose shares or debt instruments are publicly
traded on a stock exchange. Published financial statements may be printed or made available on the
company's website. In some countries, for example the UK, all limited companies must 'publish' their
annual accounts by filing them with the Registrar of Companies. They are then available to members
of the public.
These 'published' annual financial statements are general purpose financial statements or general
purpose financial reports. They contain information which may be useful to a wide range of users
external to the company. They are distinct from special purpose financial reports which are
prepared for a particular group of users and for a particular purpose. Share prospectuses and tax
computations are examples of special purpose financial reports.
Some users of published financial statements are able to obtain additional information. For example,
owners or lenders may be able to request forecasts and budgets and members of the public have
access to information in the financial press or on the internet. However, generally, most external users
have to rely on the annual financial statements as their major source of financial information.
Financial statements do not include directors' reports, statements by the chairman, management
commentaries or environmental and social reports, although these may be included in the published
annual report of a large listed company (see Module 2).
2.3 LIMITATIONS OF FINANCIAL REPORTING

General purpose financial statements cannot possibly provide all the information that external users
might need about a company or business. Users may also need to consider information from other
sources, such as general economic conditions, the political situation and conditions in the industry in
which the business operates.
There are other inherent limitations of the financial accounting and reporting process.
 Financial statements are based on estimates and judgments. For example, management must
estimate the useful lives of assets and the likelihood that amounts receivable will actually be
received. Preparing financial statements and reports involves classifying and aggregating (adding
together) information about transactions and other events. It also involves allocating the effects of
continuous business transactions over separate accounting periods.
 Financial statements are based on historical information. They do not reflect future events or
transactions that may affect the business and the way that it operates. Users of the financial
statements normally need to predict how well a business will perform in future and to understand
the factors which may affect its future performance.
 Financial statements largely record only the financial effects of transactions and events. For
example, intangible assets such as the technical expertise of the workforce may have a very
significant effect on a company's performance. However, these 'assets' are not recognised because
they cannot be reliably valued at a monetary amount. Financial statements do not include
non-financial information such as discussion of the risks and uncertainties that a business faces, or
a description of its effect on the natural environment.
Question 1: Financial reporting
Financial reporting means the financial statements produced only by a large listed company.
Is this statement correct?
A yes
B no
(The answer is at the end of the module.)
3 THE REPORTING ENTITY
Section overview
 A reporting entity is an entity whose general purpose financial statements are relied upon
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by other parties, or users of the accounts.
LO A reporting entity is defined in Australia as 'an entity in respect of which it is reasonable to expect the
1.3 existence of users who rely on the entity's general purpose financial statements for information that
will be useful to them for making and evaluating decisions about the allocation of resources. A
reporting entity can be a single entity or a group comprising a parent and all of its subsidiaries'. Only
certain regulations will apply to the reporting entity.
The 'reporting entity' concept is not, however, one that is currently adopted outside Australia and at
present International standard-setters have no official equivalent definition. Internationally therefore, a
reporting entity is taken quite simply to be an entity, or group of entities, which prepare accounts. A
project is currently underway to develop an international 'reporting entity' concept.
4 USERS' AND STAKEHOLDERS' NEEDS
Section overview
 There are various groups of people who need information about the activities of a business.
4.1 THE NEED FOR FINANCIAL STATEMENTS

The purpose of financial statements is to provide useful information about the financial position,
performance and changes in financial position of an entity to a wide range of users.
Users need this information for two reasons:
 to make economic decisions; and
 to assess the stewardship of management.
4.1.1 MAKING ECONOMIC DECISIONS

The types of economic decisions for which financial statements are likely to be used include the
following:
 decisions to buy, hold or sell equity investments;
 assessment of management stewardship and accountability;
 assessment of the entity's ability to pay employees;
 assessment of the security of amounts lent to the entity;
 determination of taxation policies;
 determination of distributable profits and dividends;
 inclusion in national income statistics; and
 regulation of the activities of entities.
4.1.2 STEWARDSHIP
Stewardship is relevant where an organisation is managed by people other than its owners. For
example, the owners of a listed company appoint directors to run the company on their behalf, who
are then accountable for the company's resources. They must use these resources efficiently and
effectively to produce profits or other benefits for the owners. Owners need to be able to assess the
performance of the directors so that they can decide whether to reappoint them or remove them and
how much they should be paid.
4.2 USERS OF FINANCIAL STATEMENTS AND ACCOUNTING

INFORMATION
LO A business should produce information about its activities because there are various groups of people
1.4 who want or need to know that information.
Large businesses are of interest to a greater variety of people and so we will consider the case of a
listed company, whose shares can be purchased and sold on a stock exchange.
The following people are likely to be interested in financial information about a company with listed
shares.
(a) Managers of the company appointed by the company's owners to supervise the day-to-day
activities of the company. They need information about the company's financial situation as it is
currently and as it is expected to be in the future. This is to enable them to manage the business
efficiently and to make effective decisions.
(b) Shareholders of the company, i.e. the company's owners, want to assess how well the
management is performing. They want to know how profitable the company's operations are and
how much profit they can afford to withdraw from the business for their own use.
(c) Trade contacts include suppliers who provide goods to the company on credit and customers who
purchase the goods or services provided by the company. Suppliers want to know about the
company's ability to pay its debts; customers need to know that the company is a secure source of
supply and is in no danger of having to close down.
(d) Providers of finance to the company might include a bank which allows the company to operate
an overdraft, or provides longer-term finance by granting a loan. The bank wants to ensure that the
company is able to keep up interest payments, and eventually to repay the amounts advanced.
(e) The taxation authorities want to know about business profits in order to assess the tax payable by
the company, including sales taxes, for example Goods and Services Tax or Value Added Tax.
(f) Employees of the company should have a right to information about the company's financial
situation, because their future careers and the size of their wages and salaries depend on it.
(g) Financial analysts and advisers need information for their clients or audience. As examples,
stockbrokers need information to advise investors; credit agencies want information to advise
potential suppliers of goods to the company; and journalists need information for their reading
public.
(h) Government and their agencies are interested in the allocation of resources and therefore in the
activities of business entities. They also require information in order to provide a basis for national
statistics.
(i) The public. Companies affect members of the public in a variety of ways. They may make a
substantial contribution to a local economy by providing employment and using local suppliers.
Another important factor is the effect of an entity on the environment as an example in relation to
pollution.
Accounting information is summarised in financial statements to satisfy the information needs of
these different groups. These information needs will differ between each user group and not all will be
equally satisfied.
4.3 NEEDS OF DIFFERENT USERS

Managers of a business need the most information, to help them make their planning and control
decisions. They clearly have 'special' access to information about the business, because they are able
to demand whatever internally produced statements they require. When managers want a large
amount of information about the costs and profitability of individual products, or different parts of
their business, they can obtain it through a system of cost and management accounting rather than
rely on the financial accounts.
Shareholders, providers of finance and financial analysts and advisers need information that helps
them to make decisions: whether to buy, hold or sell their investment in a business or whether to lend
money to it. Unlike managers, these users are external to the business. Therefore they normally have
to rely on the published financial statements to provide them with the information that they need.
For this reason, in most developed countries, including Australia, published financial statements are
primarily prepared to meet the information needs of existing and potential investors and lenders
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and their advisors.
Question 2: Information needs
Which of the following items in the financial statements of a company would be of particular interest
to a customer?
A operating profit
B retained earnings
C dividend payments
D directors' remuneration
5 THE NEED FOR A REGULATORY FRAMEWORK
Section overview
 The regulatory framework ensures that general purpose financial reporting produces
relevant and reliable information and therefore meets the needs of shareholders, lenders
and other users.
 Generally accepted accounting principles (GAAP) signifies all the rules, from whatever
source, that govern accounting. GAAP includes accounting standards (IFRS and national
standards), national company law, and local stock exchange requirements.
 Regulation of companies and their published financial information can vary significantly in
different countries throughout the world.
5.1 SUBJECT OUTLINE

LO The regulatory framework consists of accounting rules and company law. These ensure that general
1.1 purpose financial reporting provides useful information that meets the needs of shareholders, lenders
and other users.
The International Accounting Standards Board (IASB) develops and issues International Financial
Reporting Standards (IFRS). As IFRS have no jurisdiction, and the IASB has no authority to impose
accounting standards, individual countries draw up their own accounting regulations. In practice,
national governments often adopt IFRS and then adapt them to operate together with local laws and
regulations as necessary.
5.2 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

LO Generally accepted accounting principles (GAAP) signifies all the rules, from whatever source, which
1.3 govern accounting. The concept is applicable globally.
In individual countries GAAP is seen primarily as a combination of
 national company law;
 national accounting standards; and
 local stock exchange requirements.
Although these sources are the basis for the GAAP of individual countries, the concept also includes
sources such as
 international financial reporting standards; and
 accounting requirements of other countries.
In many countries, GAAP does not have any statutory or regulatory authority or definition. There are
different views of GAAP in different countries. The IASB convergence program seeks to reduce these
differences.
GAAP can be based on legislation and accounting standards that are either:
 prescriptive/rules-based; or
 principles-based.
The US operates a prescriptive system, where standards are very detailed, attempting to cover all
eventualities. Accounts which do not comply in all details are presumed to be misleading. This has the
advantage of clear requirements which can be generally understood and it removes any element of
judgment.
In general, international financial reporting standards (IFRS) are principles-based. They do not specify
all the details but seek to obtain adherence to the 'spirit' of the regulations. This leaves room for some
element of professional judgment. It also makes it harder for entities to avoid applying a standard as
the terms of reference are broader. (We will be discussing the differences between rules-based
standards and principles-based standards in more detail later in this module.)
5.2.1 INDIVIDUAL JUDGMENT

Financial statements are prepared on the basis of a number of fundamental accounting assumptions
and conventions. Many figures in financial statements are derived from the application of judgment
in putting these assumptions into practice.
It is clear that different people exercising their judgment on the same facts can arrive at very different
conclusions.
Question 3: Judgment
An accountancy training firm has an excellent reputation amongst students and employers. How
would you value this? The firm may have relatively little in the form of tangible assets that you can
touch, perhaps a building, desks and chairs. If you simply drew up a statement of financial position
showing the cost of the assets owned, then the business would not seem to be worth much, yet its
income earning potential might be high. This is true of many service organisations where the people
are among the most valuable assets. Here judgment must be used in order to reach a valuation for the
business, although one person's judgment may lead to a very different valuation from another
person's.
Can you think of any other areas where judgment would have to be used in preparing financial
statements?
5.3 ADVANTAGES AND DISADVANTAGES OF REGULATION

LO The key benefit of accounting regulation is that it requires organisations to prepare financial
1.1 statements on a consistent basis. This is useful for the users of financial statements that were
identified earlier in this module. For example, an investor wishing to purchase shares in a company is
able to compare that company's performance with another, as their financial statements should
have been prepared on the same basis.
Other advantages of regulation include:

(a) The existence of accounting rules reduces variations in the way financial statements are prepared.
Without regulation it would be possible for preparers to adopt whatever accounting treatments
they choose and to vary these from year to year in order to present the company's profit figure and
net assets in as favourable a light as possible. In addition, transactions and businesses have
become increasingly complex. There are many legitimate ways to present, measure and disclose
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items such as complex financial instruments, but the accounting treatment of these items needs to
be comparable between different entities and over time.
(b) Regulation means there will be rules as to what should be disclosed which improves the quality of
information produced. For example, IAS 1 Presentation of Financial Statements requires
companies to disclose the accounting policies that they have followed, so that users can
understand the judgments that preparers have made in arriving at the amounts in the financial
statements. Financial statements must also include supporting notes which analyse and explain the
main line items in the financial statements. Specific information that must be disclosed is set out in
accounting standards and (in some cases) companies legislation.
(c) The existence of regulation is likely to ensure that companies disclose more information about
their business activities and financial results than they may have done in the absence of such
regulation. There is an argument that companies resist disclosing information unless they are
required to do so. There are costs associated with providing financial information. Without
regulation, management is likely to be unwilling to deliver 'bad news' to investors, or to provide
information that could be used by competitors.
(d) Regulation of companies listed on stock exchanges means there are strict requirements in terms of
reporting and disclosure and this is likely to protect investors. In many countries, such as
Australia, the US and the UK, systems of accounting regulation were originally developed as a
response to high profile company failures and frauds in which many investors lost their savings.
(e) A strong system of regulation will increase public confidence in the published financial
statements of companies. This is particularly important since there have recently been a number of
high profile corporate failures contributed to by inappropriate accounting.
(f) Some users of financial statements (for example, major corporate investors and lenders) have the
power to demand the information that they need. Other users (for example, small investors and
individual members of the public) have not. Regulation protects those less powerful individuals and
organisations and can therefore be seen as a social good.
Disadvantages of regulation include:
(a) Strict regulation could mean a lack of flexibility for some businesses. Sometimes companies have
differing business environments. These companies may have to adopt accounting treatments that
do not properly reflect their financial performance and position and actually lessen the quality of
the information that they provide. In this situation, it may be impossible for users to make
meaningful comparisons between companies.
(b) Companies may incur high costs in complying with the regulatory rules. The cost of providing the
information required may outweigh the benefits of that information. This is particularly relevant
where small companies have to comply with either US regulations or the full set of International
Accounting Standards (known as 'full IFRS'). Both the US and 'full IFRS' systems were designed
primarily to meet the accounting needs of multinational organisations and to protect large
institutional investors in those organisations. They therefore include standards on topics such as
financial instruments, earnings per share, operating segment disclosure and share-based payment
transactions, which are, in most cases, not relevant to smaller entities. The IASB has now
developed a special standard for small and medium entities (the IFRS for SMEs) as an alternative to
'full IFRS'. This standard omits certain topics and simplifies others in order to lessen the regulatory
burden on smaller entities.
(c) Detailed rules and regulations may mean that companies spend a great deal of time 'box-ticking'
without considering the spirit of the regulation they are complying with. Information is provided
because it is required, even though it is of little value. The problem can be particularly acute where
preparers are required to make specific narrative disclosures, for example, about corporate
governance or future prospects for the business. Users frequently complain about 'boiler plate'
disclosures: general statements that could apply to any company and tell the reader nothing.
(d) Regulation leads to financial statements that contain too much information and this can obscure
the overall picture that they present. The length and volume of company annual reports is steadily
growing as the result of new accounting requirements. Many commentators believe that published
financial statements have become too complex for anybody other than a financial reporting expert
to understand.
Question 4: Creative accounting
Creative accounting is the name given to accounting treatments which comply with all applicable
accounting regulations but which have been deliberately manipulated to give a biased impression of a
company's performance or financial position. From the 1990s onwards, new or improved accounting
standards were developed to prevent most of these practices.
Briefly describe two possible methods of 'creative accounting'.
5.4 VARIATIONS IN REGULATORY REGIMES

LO Regulation of companies and their published financial information can vary significantly in different
1.3 countries throughout the world. There are many reasons for these differences. In some cases it is due
to differences in company structures, local culture and ownership patterns of companies.
5.4.1 COMPANY STRUCTURE AND OWNERSHIP

A country where the majority of companies are family owned with few, if any, external shareholders
outside the family will need far less regulation than a country which is dominated by large
multinational corporations with large numbers of shareholders, who have no connection to the
business. Much of the regulation in the latter case would be to ensure that companies are acting in
the best interests of shareholders. In many family companies, the shareholders and directors are the
same family members, so they will already be acting in the best interests of the shareholders and will
be concerned about the long-term future of the business.
5.4.2 LEVEL OF DEVELOPMENT

The level of development of a nation also has an impact on its level of regulation. Developing
countries are further behind in the process of setting standards and establishing regulatory regimes
than industrialised nations.
East Timor, a tiny nation in both territory and population, was officially accepted into the United
Nations as a sovereign state in 2002 after a long-running battle for independence from Indonesia. A
poor nation, it is establishing systems for long-term political and economic stability but is still
struggling with the problems facing many developing nations. It is party to international conventions
and standards (including IFRS), but lags behind in implementation. Cambodia is another example of a
Southeast Asian developing nation where conflict and resulting economic instability means it is still
'catching up' with more industrialised nations in terms of regulation adoption and implementation.
Fiji, one of the largest and economically strongest Pacific island nations, was suspended from both the
Pacific Island Forum and the Commonwealth of Nations during 2009, with both suspensions currently
remaining in force. Fiji's political upheaval means standard-setting and regulation is of low
importance.
5.4.3 DIFFERENT PURPOSES OF FINANCIAL REPORTING

In some countries the purpose of preparing financial statements is solely for tax assessment, and
therefore the accounting rules are often the same as the tax rules. In other countries, financial
statements exist to provide information for investor decision-making. This will have an impact on the
type of regulatory system in place.
5.4.4 DIFFERENT USER GROUPS
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Countries have different ideas about who the relevant user groups are and their respective
importance. User groups may include financiers, management, investors, creditors, customers,
employees, the government and the general public. In some countries investor and creditor groups
are given prominence, while in others employees enjoy a higher profile.
6 THE IFRS FOUNDATION AND THE IASB
Section overview
 The International regulatory framework consists of:
– The International Financial Reporting Standards Foundation (IFRS Foundation)
– The International Accounting Standards Board (IASB)
– The International Financial Reporting Standards Advisory Council
– The International Financial Reporting Standards Interpretations Committee.
 IFRS are developed through a formal system of due process and broad international
consultation involving accountants, financial analysts and other users and regulatory bodies
from around the world.
6.1 SUBJECT OUTLINE

The IFRS Foundation is an independent, not-for-profit private sector organisation working in the
public interest. It was founded in March 2001 as the International Accounting Standards Committee
(IASC) Foundation and is the parent entity of the IASB. The IFRS Foundation publishes and promotes
IFRS. Its mission statement is 'To develop IFRS Standards that bring transparency, accountability and
efficiency to financial markets around the world'.
The governance and oversight of the IFRS Foundation and its standard-setting bodies rests with the
Trustees. They are also responsible for promoting IFRS and securing the organisation's funding. The
Trustees are appointed for a renewable term of three years and must have an understanding of the
issues relevant to the setting and development of IFRS but are not involved in a technical capacity. Six
of the Trustees must be selected from the Asia/Oceania region, six from Europe, six from North
America, one from Africa, one from South America and two from the rest of the world.
A Monitoring Board (established in 2009) provides a formal link between the Trustees and public
capital market authorities. The Monitoring Board participates in the process for appointing Trustees
and approves their appointment. It also advises the Trustees, who are required to report to it annually,
and review their work. The Monitoring Board has six members drawn from the European Commission,
the International Organization of Securities Commissions (IOSCO), the US Securities and Exchange
Commission (SEC) and other regulatory bodies.
LO The International Accounting Standards Board is the standard-setting body and is an independent,
1.5 privately-funded accounting standard setter based in London. It is a part of the International
regulatory framework, reporting to the IFRS Foundation.
From April 2001 the IASB assumed accounting standard setting responsibilities from its predecessor
body, the International Accounting Standards Committee (IASC).
The IASB has an important role to play in the regulation of financial information as it is responsible for
issuing IFRS, which are then adopted for use in many different jurisdictions. Since 2001, almost 120
countries have required or permitted the use of IFRS in preparing financial information which makes
the IASB the most important accounting body worldwide. Most of the remaining major economies,
other than the US, have timelines in place for the move from national accounting standards to
convergence with IFRS in the near future.
6.2 THE COMPOSITION OF THE IASB

The IASB is an independent group of experts with recent relevant practical experience. Its members
are selected so that there is a mix of auditors, preparers, users and academics.
The 12 members of the IASB come from many different countries and have a diverse range of
backgrounds. There are currently three members from the Asia/Oceania region; three members from
Europe; two members from North America; one member from Africa; one member from South
America; and two members appointed from any area, subject to maintaining overall geographical
balance.
The IASB aims to be collaborative in its development of standards by engaging with the worldwide
standard setting community as well as investors, regulators, business leaders and the global
accountancy profession.
6.3 OBJECTIVES OF THE IFRS FOUNDATION AND THE IASB

The formal objectives of the IFRS Foundation and IASB are:
(a) To develop, in the public interest, a single set of high quality, understandable, enforceable and
globally accepted financial reporting standards based upon clearly articulated principles. These
standards should require high quality, transparent and comparable information in financial
statements and other financial reporting to help investors, other participants in the world's capital
markets and other users of financial information to make economic decisions
(b) To promote the use and rigorous application of those standards.
(c) To take account of the needs of a range of sizes and types of entities in diverse economic settings.
(d) To promote and facilitate adoption of International Financial Reporting Standards (IFRSs), being
the standards and interpretations issued through the IASB, through the convergence of national
accounting standards and IFRSs.
6.4 STRUCTURE OF THE IFRS FOUNDATION

The structure of the IFRS Foundation has the following main features:
(a) The IFRS Foundation oversees two main areas – the standard-setting process and the IFRS
Advisory Council (previously known as the Standards Advisory Council).
(b) The standard-setting process consists of two bodies, the IASB (as discussed above) and the IFRS
Interpretations Committee. The IASB has the sole responsibility for setting international financial
reporting standards.
(c) The IFRS Interpretations Committee (previously known as the International Financial Reporting
Interpretations Committee or IFRIC) comprises 14 voting members drawn from a variety of
countries and professional backgrounds. The IFRS Interpretations Committee provides timely
guidance on the application and interpretation of IFRS. It deals with newly identified financial
reporting issues not specifically addressed in IFRS, or issues where unsatisfactory or conflicting
interpretations have developed, or seem likely to develop.
(d) The IFRS Advisory Council (previously the Standards Advisory Council) is the formal advisory body
to the IASB and Trustees of the IFRS Foundation. It is comprised of a wide range of representatives
from user groups, preparers, financial analysts, academics, auditors, regulators, professional
accounting bodies and investor groups that are affected by and interested in the IASB's work.
Members of the Advisory Council are appointed by the Trustees. It meets three times a year to
advise the IASB on a range of issues including the IASB's agenda and work program.
The structure of the IFRS Foundation can be illustrated as follows:
Monitoring Board
of public capital market authorities
appoints, monitors report to
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IFRS Foundation Trustees
(Governance)
oversee, review effectiveness,

appoint inform informs
appoint and finance
IFRS Advisory Council Standard-setting
International Accounting Standards Board (IASB)

(IFRS/IFRS for SMEs)
provides
strategic
advice
IFRS Interpretations Committee
IFRS Foundation support operations

Education Initiative, IFRS Taxonomy (XBRL), Content Services
6.5 THE STANDARD SETTING PROCESS

LO IFRS are developed through a formal system of due process and broad international consultation
1.5 involving accountants, financial analysts and other users and regulatory bodies from around the world.
The process of developing an accounting standard has six stages as follows:
Step 1 Setting the agenda. The IASB evaluates the merits of adding a potential item to its
agenda mainly by reference to the needs of investors.
The IASB considers:
 the relevance to users of the information and the reliability of information that could
be provided;
 whether existing guidance is available;
 the possibility of increasing convergence;
 the quality of the standard to be developed; and
 resource constraints.
The IFRS Advisory Council and the IFRS Interpretations Committee, other standard-
setters and other interested parties may have made comments on accounting issues that
could become potential agenda items.
Step 2 Planning the project. When adding an item to its work agenda, the IASB considers
whether to conduct the project alone or jointly with another standard setter. A working
group is usually formed at this stage and the project plan is developed.
Step 3 Developing and publishing the discussion paper. It is not mandatory for the IASB to
issue a discussion paper in the development of a standard, but it is usual practice where
there is a major new topic being developed and the IASB wish to set out their position
and invite comments at an early stage in the process. Typically, a discussion paper
includes:
 a comprehensive overview of the issue;
 possible approaches in addressing the issue;
 the preliminary views of its authors or the IASB; and
 an invitation to comment.
Step 4 Developing and publishing the exposure draft. This is a mandatory step in the due
process. Regardless of whether a discussion paper has been published, the exposure
draft is the IASB's main means of consulting the public on the proposed standard. The
exposure draft sets out the proposed standard in detail. The development of the
exposure draft begins with the IASB considering the following:
 issues on the basis of staff research and recommendations;
 comments received on the discussion paper (if one was published); and
 suggestions made by the IFRS Advisory Council, working groups, other standard-
setters and public meetings where the proposed standard was discussed.
Once the exposure draft has been published the IASB again invites comments.
Step 5 Developing and publishing the standard. The development occurs at IASB meetings
when the IASB considers the comments received on the exposure draft. The IASB must
then consider whether a second exposure draft should be published. The IASB needs to:
 identify substantial issues that emerged during the comment period on the exposure
draft that it had not previously considered;
 assess the evidence that has been considered;
 evaluate whether it has sufficiently understood the issues and obtained the views of
constituents; and
 consider whether the various viewpoints were aired in the exposure draft and
adequately discussed and reviewed in the basis for conclusions.
If the IASB decides that the exposure draft should be republished then the same process
should be followed as for the first exposure draft. Once the IASB is satisfied that the
issues raised have been dealt with, the IFRS is drafted.
Step 6 After the standard is issued. After an IFRS is issued, IASB holds regular meetings with
interested parties, including other standard-setting bodies, to help understand
unanticipated issues related to the practical implementation and potential impact of its
proposals. If there are concerns about the quality of the standard from the IFRS Advisory
Council, the IFRS Interpretations Committee, standard-setters and constituents, then the
issue may be added to the IASB agenda and the process reverts back to Step 1.
Post-implementation reviews are carried out for each new standard, generally after the
requirements have been applied for two years internationally.
The standard setting process can be illustrated in the diagram below:

RESEARCH
Discussion
Paper (DP)
Optional
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PUBLIC CONSULTATION
PROPOSAL Extensive
outreach
activities
Exposure
Draft
(ED)
Input
into standard
setting process PUBLIC
CONSULTATION
Published Feedback
IFRS Statement
IASB post-implementation review
6.6 CONSULTATION WITH NATIONAL STANDARD-SETTERS

The development of an IFRS involves an open, public process of debating technical issues and
evaluating input sought through several mechanisms. Opportunities for interested parties to
participate in the development of IFRS would include, depending on the nature of the project:
(a) participation in the development of views as a member of the IFRS Advisory Council;
(b) participation in advisory groups;
(c) submission of a comment letter in response to a discussion document;
(d) submission of a comment letter in response to an Exposure Draft;
(e) participation in public hearings; and/or
(f) participation in field visits and field tests.
The IASB publishes an annual report on its activities during the past year and priorities for next year.
This report provides a basis and opportunity for comment by interested parties. In addition, it also
undertakes a public consultation on its future technical agenda every three years. The first of these
public consultations took place in the second half of 2011 and the second public consultation was in
August 2015.
The IASB reports on its technical projects on its website. It also publishes a report on IASB decisions
immediately after each IASB meeting in its newsletter IASB Update.
6.7 THE NEED FOR INTERNATIONAL STANDARDS

Although the predecessor organisation of the IFRS Foundation was set up in the 1970s, the
development of International standards has grown in importance in the last 10 years. As business and
LO
commerce became more global in nature, many interested parties began to understand the need for
1.4
a common set of accounting standards. Until that point, many multinational companies prepared
financial statements under a variety of GAAPs, which was costly. This also had an impact on the
auditors of those financial statements and current and future investors. Companies with stock
exchange listings in more than one jurisdiction had to prepare different sets of financial statements for
each jurisdiction which was viewed as inefficient.
The original International Accounting Standards were deliberately drafted to be flexible and to allow
choices. From the 1990s onwards it became increasingly clear that it was not enough to have a set of
international standards with which most countries could comply. These standards had to be
sufficiently rigorous to be acceptable to all stock exchanges, including those in the US.
The starting point for the rapid change of the last few years was the acceptance of international
accounting standards for cross border listings by the International Organisation of Securities
Commissions (IOSCO). International standards gained more prominence when the European Union
decided that from 2005, the consolidated financial statements of companies in the member states
would be prepared under international standards. IFRS became the global standards that were
needed and since then many countries, including Australia and South Africa, have adopted IFRS as
their national standards or have a program in place to adopt international standards in the near future.
6.7.1 BENEFITS OF HARMONISATION

There are several general benefits of harmonisation:
 Investors and lenders, both individual and corporate, need to be able to compare the financial
results of different companies internationally as well as nationally in making investment
decisions. Differences in accounting practice and reporting can prove to be a barrier to such cross-
border analysis. Harmonisation of financial reporting benefits investors, lenders and their
advisors, because it provides them with better quality information on which to base economic
decisions. Users no longer have to understand several different national GAAPs or to incur the
costs of adjusting financial statements in order to compare them with each other.
 Harmonisation benefits the global economy, because it makes it removes barriers to the flow of
capital between countries. It is easier for businesses to expand into and raise finance in
countries other than their own.
 Robust international financial reporting standards are also needed to protect investors and to
restore public confidence in financial reporting following the failure of several banks (notably
Lehman Brothers in 2008) and the resulting 'credit crunch' and global financial crisis. One of the
actions agreed upon by the G-20 leaders (finance ministers and central bank governors from the
world's largest economies), in their summit meetings after the crisis, was that the key global
accounting standards bodies should work intensively towards the objective of creating a single set
of high quality global standards.
A full list of countries adopting IFRS and their progress can be found on
http://www.iasplus.com/en/resources/ifrs-topics
We look at the harmonisation process in more detail later in this module.
6.7.2 BARRIERS TO HARMONISATION

There are undoubtedly many barriers to full international harmonisation. Problems include the
following:
 Different purposes of financial reporting. In some countries the purpose is solely for tax
assessment, while in others it is for investor decision-making.
 Different legal systems. These may prevent the development of certain accounting practices and
restrict the options available.
 Different user groups. Countries have different ideas about who are the relevant user groups and
their respective importance. In the US investor and creditor groups are given prominence, while in
Europe employees enjoy a higher profile.
 Needs of developing countries. Developing countries are clearly behind in the standard-setting
process and they need to develop the basic standards and principles already in place in most
developed countries.
 Nationalism is demonstrated in an unwillingness to accept another country's standard.
 Cultural differences result in objectives for accounting systems differing from country to country.
 Unique circumstances. Some countries may be experiencing unusual circumstances which affect
all aspects of everyday life and impinge on the ability of companies to produce proper reports, for
example hyperinflation, civil war, currency restriction and so on.
 The lack of strong accountancy bodies. Many countries do not have strong independent
accountancy or business bodies which would press for better standards and greater harmonisation.
These are difficult problems to overcome, and yet attempts are being made continually to do so. We
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must therefore consider what the perceived advantages of harmonisation are, which justify so much
effort.
6.8 BENEFITS OF IFRS FOR NATIONAL JURISDICTIONS

The advantages of IFRS described above apply to individual nations. If it is possible to compare the
financial statements of an entity in one country with those of another entity located in a different
country it becomes easier to do business with overseas companies. This benefits national economies,
as well as the global economy.
In its 2002 policy statement International Convergence and Harmonisation Policy the Australian
Accounting Standards Board listed the following additional benefits of adopting IFRS:
 increasing the understanding by foreign investors of Australian financial reports;
 reducing financial reporting costs for Australian multinational companies and foreign companies
operating in Australia and reporting elsewhere;
 facilitating more meaningful comparisons of the financial performance and financial position of
Australian and foreign public sector reporting entities; and
 improving the quality of financial reporting in Australia to best international practice.
There are a number of further potential benefits for national jurisdictions:
 Many developing nations who do not have the resources to develop and implement their own
national standards can adopt IFRS as a full set of standards. This is perhaps more relevant since
the issue of the IFRS for SMEs as previously the level of detail in standards and the amount of
disclosure required was a barrier to adoption of IFRS in developing countries.
 It may be easier for national governments to control the activities of foreign multinational
companies that carry out operations within their territory. These companies would not be able to
'hide' behind foreign accounting practices which are difficult to understand.
 Tax authorities may find it easier to calculate the tax liability of investors.
Many national standard setting bodies are experiencing a change in their role as IFRS have become
more important. Many standard setters no longer develop and issue their own accounting standards
and instead comment on the work of the IASB, the impact of new IFRS and changes to existing IFRS
on their home jurisdiction. National standard setting bodies may also undertake research on behalf of
the IASB on particular projects.
6.9 OTHER INTERNATIONAL INFLUENCES

There are a number of other international bodies that have been involved in the recent trend of
moving to IFRS. They are discussed briefly below.
6.9.1 IASB AND THE EUROPEAN COMMISSION

The European Commission (EC) has acknowledged the role of the IASB in harmonising world-wide
accounting rules and EC representatives attend IASB Board meetings and have joined Steering
Committees involved in setting IFRS.
The EC has also set up a committee to investigate where there are conflicts between European Union
norms and International Standards so that compatibility can be achieved. In turn, the IASB has used
EC Directives in its work.
From 2005, all listed entities in member states have been required to use IFRS in their
consolidated financial statements.
6.9.2 UNITED NATIONS (UN)

The UN has a Commission and Centre on Transnational Reporting Corporations through which it
gathers information concerning the activities and reporting of multinational companies. The UN
processes are highly political and probably reflect the attitudes of the governments of developing
countries towards multinationals. For example, there is an inter-governmental working group of
'experts' on international standards of accounting and reporting which is dominated by the non-
developed countries.
6.9.3 INTERNATIONAL FEDERATION OF ACCOUNTANTS (IFAC)

The IFAC is a private sector body established in 1977 and which now consists of over 100 professional
accounting bodies, including CPA Australia, from around 80 different countries. The IFAC's main
objective is to co-ordinate the accounting profession on a global scale by issuing and establishing
International Standards on auditing, management accounting, public sector accounting, ethics,
education and training. The IFAC has separate committees working on these topics and also
organises the World Congress of Accountants, which is held every four years.
6.9.4 ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT (OECD)

The OECD was established in 1960 by the governments of 21 countries to 'achieve the highest
sustainable economic growth and employment and a rising standard of living in member countries
while maintaining financial stability and, thus, to contribute to the world economy'. It now has 35
member countries.
The OECD's aim is to bring together the governments of countries committed to democracy and the
market economy from around the world to:
 support sustainable economic growth;
 boost employment;
 raise living standards;
 maintain financial stability;
 assist other countries' economic development; and
 contribute to growth in world trade.
The Organisation provides a setting where governments compare policy experiences, seek answers to
common problems, identify good practice and coordinate domestic and international policies.
The OECD supports the work of the IASB but also undertakes its own research into accounting
standards via ad hoc working groups. The OECD also produces its own corporate governance
principles and other publications aimed at improving financial reporting, regulation and removing
corruption.
6.9.5 AUSTRALIAN ACCOUNTING STANDARDS BOARD (AASB)

LO The AASB is an independent accounting standard setting body based in Melbourne. The functions of
1.1 the AASB under the Australian Securities and Investments Commission (ASIC) 2001 Act are:
 to develop a conceptual framework, not having the force of an accounting standard, for the
purpose of evaluating proposed accounting standards and international standards;
 to make accounting standards under section 334 of the Corporations Act 2001 for the purposes of
the corporations legislation (other than the excluded provisions);
 to formulate accounting standards for other purposes;
 to participate in and contribute to the development of a single set of accounting standards for
worldwide use; and
 to advance and promote the main objects of Part 12 of the Australian Securities and Investments
Commission Act, with regard to the interests of Australian corporations which raise or propose to
raise capital in major international financial centres.
The mission of the AASB is to:

 develop and maintain a high-quality conceptual framework for all sectors of the Australian
economy;
 develop and maintain high quality accounting (i.e. financial reporting) standards for reporting
entities in those sectors; and
 contribute, through thought leadership and participation, in the development of global financial
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reporting standards and standard-setting.
The Australian process of harmonisation with IFRS has been to issue IFRS-equivalent standards, i.e.
adopt the content of IFRS with minor changes made to refer to the Australian legislative environment.
The audit report of a company's financial statements states that they have been prepared in
compliance with IFRS.
The AASB issues standards that apply to both for-profit and not-for-profit entities. Standards issued by
the International Accounting Standards Committee (IASC), the predecessor of the IASB, are
designated as IAS 1, IAS 2 etc. The Australian equivalents are AASB 101, AASB 102 etc. Standards
issued by the IASB are designated as IFRS 1, FRS 2 etc, and the Australian equivalents are AASB 1,
AASB 2 etc.
6.10 TRUE AND FAIR VIEW/FAIR PRESENTATION

It is a requirement of national legislation in some countries that the financial statements should give a
true and fair view of (or 'present fairly, in all material respects') the financial performance and position
of the entity as at the end of the financial year. Despite this, the terms 'true and fair view' and 'present
fairly, in all material respects' are not defined in accounting or auditing standards.
In some jurisdictions a company's managers may depart from any of the provisions of accounting
standards if these are inconsistent with the requirement to give a true and fair view. This is commonly
referred to as the 'true and fair override'. It has been treated as an important loophole in the law in
different countries and has been the cause of much argument and dissatisfaction within the
accounting profession. For example, it is not recognised in Australia, where it was removed from
legislation in 1991. Australian regulators and bodies want the accounting standards (and the true and
fair view being established by them) given primacy. In Australia therefore, directors are required to
provide additional information in order to comply with the true and fair view, as they cannot depart
from any of the provisions of the accounting standards.
6.11 THE IASB AND CURRENT ACCOUNTING STANDARDS

The IASB's predecessor body, the IASC, had issued 41 International Accounting Standards (IASs) and
on 1 April 2001 the IASB adopted all of these standards and now issues its own International Financial
Reporting Standards (IFRS). So far sixteen new IFRS have been issued as well as the IFRS for small and
medium-sized enterprise (SMEs). From now on in this Study Guide we will use the phrase 'IFRS' for all
International Accounting Standards unless we are specifically discussing a particular IAS.
6.12 THE IASB AND FASB

The IASB and the US Financial Accounting Standards Board (FASB) have been working together
since 2002 to achieve convergence of IFRS and US GAAP. Both parties set out their agreement in a
Memorandum of Understanding known as the Norwalk Agreement. Their work plan was set out in a
roadmap for convergence which outlined their targets over the period up to 2008 (see also later in this
module).
In 2007, the US Securities and Exchange Commission (SEC) removed the necessity for a reconciliation
between IFRS and US GAAP for non-US companies that were listed in the US providing their financial
statements complied with IFRS.
In 2008, and again in 2010, the Memorandum of Understanding was updated, setting out the
objectives for the period to 2011 in the convergence of US GAAP and IFRS. The IASB and the FASB
set a June 2011 target date for those projects deemed to be most important, leaving those with a
lesser degree of importance to be dealt with later. The following projects were completed in June
2011:
 business combinations;
 consolidation;
 derecognition of financial instruments;
 fair value measurement;
 financial statement presentation;
 joint arrangements; and
 post-employment benefits.
The IASB and FASB have also worked together on the following projects:
 financial instruments;
 leases; and
 insurance contracts.
They published a joint progress report in 2012 on progress made on financial instruments, and in 2013
they issued a high level update on the status and timeline of the remaining projects.
The IASB has also worked with the FASB to develop a common conceptual framework. This is
intended to provide a sound foundation for developing future accounting standards.
The IASB Conceptual Framework for Financial Reporting is discussed later in this module.
CHECKPOINT 1
 Accounting is the process of recording, analysing and summarising transactions of a business and
communicating that information to decision makers.
 A business is an entity which exists to make a profit.
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 There are three main types of business entity: sole traders, partnerships and limited liability
companies.
 Non-commercial undertakings such as charities and clubs may also prepare accounts.
 Financial reporting is the process of classifying, recording and presenting financial data in
accordance with generally established concepts and principles.
 A reporting entity is an entity whose general purpose financial statements are relied on by users of
accounts.
 There are various groups of people who need information about the activities of a business.
 The regulatory framework is the most important element in ensuring that general purpose financial
reporting produces relevant and reliable information and therefore meets the needs of
shareholders, lenders and other users.
 As the IASB has no power to regulate the use of IFRS, regulation takes place at a national level.
 The organisational structure for International financial reporting consists of:
– the IFRS Foundation;
– the IASB;
– the IFRS Advisory Council; and
– the IFRS Interpretations Committee.
 IFRS are developed through a formal system of due process and broad international consultation
involving accountants, financial analysts and other users and regulatory bodies from around the
world.
 There are a number of benefits of harmonisation including the facilitation of cross-border
investment and financing.
QUICK REVISION QUESTIONS 1
1 What is the main aim of accounting?

A to produce a trial balance
B to record every financial transaction individually
C to maintain ledger accounts for every asset and liability
D to provide financial information to users of such information
2 Which of the following groups of users would primarily be interested in a company's annual
published financial statements?
A shareholders and suppliers
B management and employees
C shareholders and providers of finance
D general public, environmental pressure groups
3 Are the following statements true or false?

 The shareholder is only interested in a statement of financial prospects, i.e. an indication of
future progress.
 The supplier of goods on credit is only interested in a statement of financial position, i.e. an
indication of the current state of affairs.
Shareholder Supplier
A true true
B true false
C false true
D false false
4 Which of the following statements concerning the International Accounting Standards Board is
true?
I It develops and ultimately issues International Financial Reporting Standards (IFRSs).
II The IASB is accountable to the International Accounting Standards Committee (IASC).
A I only
B II only
C both I and II
D neither I nor II
5 Which of the following statements is true?

A The IASB appoints the Trustees of the IFRS Foundation.
B The IFRS Foundation develops and issues Interpretations.
C The IFRS Interpretations Committee oversees the work of the IFRS Foundation.
D The IFRS Advisory Council assists and advises the IASB in the process of developing IFRSs.
6 Which of these statements are correct?

I The IASB has the objective of enforcing IFRS.
II The IASB is responsible for developing and issuing IFRS.
A I only
B II only
C both I and II
D neither I nor II
7 Which committee of the IASB provides guidance on the application of IFRS?

A IFRS Foundation
B IFRS Advisory Council
C IFRS Interpretations Committee
D International Accounting Standards Committee
8 What is the correct definition of GAAP?
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A national accounting standards and company law
B national accounting standards, stock exchange rules and company law
C international accounting standards, company law and stock exchange rules
D national accounting standards, international accounting standards, stock exchange rules and
company law
9 Which of the following is an advantage of regulation of company financial statements?

A lower costs of producing financial information
B higher quality financial information is produced
C more financial information available for competitors
D less disclosure of a company's activities in financial statements
10 What is the correct order for the process of issuing a new IFRS by the IASB?
A Discussion Paper, Standard
B Exposure Draft, Discussion Paper, Review
C Exposure Draft, Discussion Paper, Standard
D Discussion Paper, Exposure Draft, Standard
7 CONCEPTUAL FRAMEWORK AND GAAP
Section overview
 A conceptual framework is a statement of generally accepted theoretical principles which
form the frame of reference for financial reporting.
 There are advantages and disadvantages to having a conceptual framework.
7.1 THE SEARCH FOR A CONCEPTUAL FRAMEWORK

LO A conceptual framework is a statement of generally accepted theoretical principles which form the
1.6 frame of reference for financial reporting.
The financial reporting process is concerned with providing information that is useful in the business
and economic decision-making process. Therefore, a conceptual framework forms the theoretical
basis for determining which events should be accounted for, how they should be measured and how
they should be communicated to the user.
7.2 THE NEED FOR A CONCEPTUAL FRAMEWORK

Definition
A conceptual framework is a coherent system of interrelated objectives and fundamental concepts

LO that prescribes the nature, function and limits of financial accounting and reporting. (FASB)
1.6
A conceptual framework is a coherent system of concepts that flow from an objective. The objective
of financial reporting is the foundation of the framework. The other concepts provide guidance on
identifying the boundaries of financial reporting, selecting the transactions, other events and
circumstances to be represented; how they should be recognised and measured (or disclosed); and
how they should be summarised and communicated in financial reports. (IASB: Exposure Draft of an
Improved Conceptual Framework for Financial Reporting, 2008)
A conceptual framework is an important part of the financial reporting system as it underpins the
development of accounting standards and sets out the basis of recognition of items in the financial
statements such as assets, liabilities, income and expenses. It provides the basis for the development
of new accounting standards and the evaluation of those already in existence.
Where an agreed framework exists, the standard-setting body acts as an architect or designer,
building accounting rules on the foundation of sound, agreed basic principles.
7.3 ADVANTAGES AND DISADVANTAGES OF A CONCEPTUAL

FRAMEWORK
LO Advantages
1.6
(a) The situation is avoided whereby standards are developed on a piecemeal basis as a reaction to
a particular accounting problem which has emerged. In this situation, resources may be channelled
into standardising accounting practice in that area, without regard to whether that particular issue
is necessarily the most important issue at that time. Standards developed in this way may be
inconsistent with basic concepts and with each other.
(b) The situation is also avoided where there are significant 'gaps' and certain topics are never
addressed. For example, before the development of the IASB's and the US FASB's conceptual
frameworks there were no formal definitions of terms such as 'asset', 'liability' or 'equity'.
(c) The development of certain standards (particularly national standards) has been subject to
considerable political interference from interested parties. Where there is a conflict of interest
between user groups on which policies to choose, policies deriving from a conceptual framework
will be less open to criticism that the standard-setter acceded to external pressure.
(d) The existence of a framework of principles means that it is much harder for preparers to avoid
complying with reporting requirements. Rules can be avoided, but preparers must apply the
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'spirit' and reasoning behind standards based on principles.
(e) Standard setters may become more accountable to the users of financial statements, because the
reasoning behind specific standards should be clear. It should also be clear to users when standard
setters have departed from the principles set out in the framework.
(f) The process of developing standards should be easier and less costly because the basic
principles that underpin them have already been debated and established.
(g) Business is becoming increasingly complex. Accounting standards cannot cover all eventualities
and in practice the development of standards has lagged behind the growth in particular types of
complex transaction (for example in 'off balance sheet' finance). A conceptual framework provides
principles that can be applied where there is no relevant accounting standard or other
guidance.
(h) The existence of a conceptual framework contributes to the general credibility of financial
reporting and increases public confidence in financial statements.
Disadvantages
(a) Financial statements are intended for a variety of users, and it is not certain that a single
conceptual framework can be devised which will suit all users.
(b) Given the diversity of user requirements, there may be a need for a variety of accounting
standards, each produced for a different purpose (and with different concepts as a basis).
(c) It is not clear that a conceptual framework makes the task of preparing and then implementing
standards any easier than without a framework.
(d) In practice, conceptual frameworks can lead to accounting standards which are very theoretical
and academic. They may increase the complexity of financial information and lead to solutions
that are conceptually pure but are difficult to understand and apply for many preparers and users.
(e) Conceptual frameworks tend to focus on the usefulness of financial information in making 'hold or
sell' decisions about an investment. However, many users of financial statements are also
interested in information that will help them assess the stewardship of management.
(f) In addition, accounting principles focus only on economic phenomena: transactions that can be
expressed in money terms. Many believe that other aspects of an entity's operations, such as its
effect on the natural environment or on the wider community, should be at least equally important
in assessing its performance and making investment decisions.
Before we look at the IASB's attempt to produce a conceptual framework, we need to consider
another element of importance to this debate: Generally Accepted Accounting Principles or GAAP.
7.4 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

We defined GAAP earlier in this module as all of the rules, from whatever source, which govern
accounting.
There are different views of GAAP in different countries. The UK position can be explained in the
following extracts from UK GAAP (Davies, Paterson & Wilson, Ernst & Young, 5th edition).
'Our view is that GAAP is a dynamic concept which requires constant review, adaptation and
reaction to changing circumstances. We believe that use of the term 'principle' gives GAAP an
unjustified and inappropriate degree of permanence. GAAP changes in response to changing
business and economic needs and developments. As circumstances alter, accounting practices are
modified or developed accordingly… We believe that GAAP goes far beyond mere rules and
principles, and encompasses contemporary permissible accounting practice.
'It is often argued that the term 'generally accepted' implies that there must exist a high degree of
practical application of a particular accounting practice. However, this interpretation raises certain
practical difficulties. For example, what about new areas of accounting which have not, as yet, been
generally applied? What about different accounting treatments for similar items – are they all
generally accepted?
'It is our view that 'generally accepted' does not mean 'generally adopted or used'. We believe that,
in the UK context, GAAP refers to accounting practices which are regarded as permissible by the
accounting profession. The extent to which a particular practice has been adopted is, in our opinion,
not the overriding consideration. Any accounting practice which is legitimate in the circumstances
under which it has been applied should be regarded as GAAP. The decision as to whether or not a
particular practice is permissible or legitimate would depend on one or more of the following factors:
 Is the practice addressed either in the accounting standards, statute or other official
pronouncements?
 If the practice is not addressed in UK accounting standards, is it dealt with in International
Accounting Standards, or the standards of other countries such as the US?
 Is the practice consistent with the needs of users and the objectives of financial reporting?
 Does the practice have authoritative support in the accounting literature?
 Is the practice being applied by other companies in similar situations?
 Is the practice consistent with the fundamental concept of 'true and fair'?
This view is not held in all countries. In the US particularly, the equivalent of a 'true and fair view' is
'fair presentation in accordance with GAAP'. Generally Accepted Accounting Principles are defined as
those principles which have 'substantial authoritative support'. Therefore, accounts prepared in
accordance with accounting principles for which there is not substantial authoritative support are
presumed to be misleading or inaccurate.
The effect here is that 'new' or 'different' accounting principles are not acceptable unless they have
been adopted by the mainstream accounting profession, usually the standard-setting bodies and/or
professional accountancy bodies. This is much more rigid than the UK view expressed above.
In contrast, however, in Australia there does not seem to be any strong body of opinion on GAAP.
GAAP is only used by Australian companies if they need to prepare financial statements to US
standards in order to raise funds from, or obtain a listing, in the US. Otherwise, Australian companies
implement IFRS and the pronouncements of the IASB and AASB.
8 THE IASB'S CONCEPTUAL FRAMEWORK
Section overview
 The Conceptual Framework provides the theoretical framework for the development of
IFRS.
The IASB's Conceptual Framework for Financial Reporting is, in effect, the theoretical framework
upon which all IFRS are based and therefore determines how financial statements are prepared and
the information they contain.
The Conceptual Framework consists of several sections or chapters, following on after a preface and
introduction. Some of these chapters have been adopted from the previous 'Framework for the
Preparation and Presentation of Financial Statements' and will be replaced in due course.
The chapters are as follows:
 the objective of general purpose financial reporting (see below);
 the reporting entity (not yet issued);
MODULE 1
 qualitative characteristics of useful financial information (see later in this module); and
 the Framework 1989
– underlying assumption – going concern (see below)
– the elements of financial statements (see below)
– recognition of the elements of financial statements (see below)
– measurement of the elements of financial statements (see Module 2)
– concepts of capital and capital maintenance (see Module 2)
8.1 INTRODUCTION
The introduction to the Conceptual Framework points out the fundamental reason why financial
statements are produced worldwide, i.e. to satisfy the requirements of external users, but that
practice varies due to the individual pressures in each country. These pressures may be social,
political, economic or legal, but they result in variations in practice from country to country, including
the form of statements, the definition of their component parts (assets, liabilities, equity, income,
expenses), the criteria for recognition of items and both the scope and disclosure of financial
statements.
The IASB wishes to narrow these differences by harmonising all aspects of financial statements, including
the regulations governing their accounting standards and their preparation and presentation.
The introduction emphasises the way financial statements are used to make economic decisions.
Question 5: Economic decisions
Financial statements provide information that helps users to make economic decisions. What are the
main types of economic decision for which financial statements are likely to be used?
8.2 PURPOSE AND STATUS

The introduction gives a list of the purposes of the Conceptual Framework.
(a) assist the members of the IASB in the development of future IFRS and in its review of existing
IFRS
(b) assist the members of the IASB 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 IFRS
(c) assist national standard-setting bodies in developing national standards
(d) assist preparers of financial statements in applying IFRS and in dealing with topics that have yet
to form the subject of an IFRS
(e) assist auditors in forming an opinion as to whether financial statements comply with IFRS
(f) assist users of financial statements in interpreting the information contained in financial
statements prepared in compliance with IFRS
(g) provide those who are interested in the work of IASB with information about its approach to the
formulation of IFRS
The Conceptual Framework itself is not an International Financial Reporting Standard and so does not
overrule any individual IFRS. In the rare cases of conflict between an IFRS and the Conceptual
Framework, the IFRS will prevail. These cases will diminish over time to the extent that the
Conceptual Framework is used as a guide in the production of future IFRS. The Conceptual
Framework itself will be revised occasionally depending on the experience of the IASB in using it.
8.3 SCOPE
The Conceptual Framework deals with:
(a) the objective of financial reporting;
(b) the qualitative characteristics that determine the usefulness of information in financial statements;
(c) the definition, recognition and measurement of the elements from which financial statements
are constructed; and
(d) concepts of capital and capital maintenance.
The Conceptual Framework is concerned with general purpose financial reporting. The term is not
defined or discussed in the Conceptual Framework, but generally means a normal set of annual
financial statements or published annual report available to users outside the reporting entity (see
section 2.2).
9 THE OBJECTIVE OF GENERAL PURPOSE

FINANCIAL REPORTING
Section overview
 The Conceptual Framework states that:
'The objective of general purpose financial reporting is 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.'
These decisions involve buying, selling or holding equity shares and debt instruments (such as loan
stock or debentures) and providing or settling loans and other forms of credit.
The Conceptual Framework explains that investors and lenders must normally rely on general
purpose financial reports for most of the financial information that they need. Therefore they are the
primary users to which general purpose financial reports are directed.
The focus is on capital providers as the primary users of financial statements. Traditionally, in many
countries there has been a second objective of financial statements: to show the results of the
stewardship of management (the accountability of management for the resources entrusted to it).
The revised Conceptual Framework does not explicitly state this or use the term 'stewardship'. It does,
however explain that investors and other capital providers need information about how efficiently and
effectively the entity's management and governing board have discharged their responsibilities to use
the entity's resources. These responsibilities may include the protection of the entity's resources from
unfavourable effects of economic factors (such as price changes) and compliance with applicable laws
and regulations.
General purpose financial reports cannot provide all the information that investors, lenders and other
creditors need. They may also need to consider relevant information from other sources, for
example, general economic conditions and expectations, political events and information about the
industry in which the company operates.
The Conceptual Framework explains that other users, such as regulators and members of the public
may also find general purpose financial reports useful. However, financial reports are not primarily
prepared for these groups of users.
Question 6: Users of financial information
Earlier in this module, we discussed the users of accounting information. List the seven groups of users
and describe the information needs of each group.
MODULE 1
9.1 ECONOMIC RESOURCES, CLAIMS AND CHANGES IN RESOURCES
AND CLAIMS
Financial reports provide information about the financial position of an entity:
(a) its economic resources; and
(b) the claims against it.
They also provide information about changes in an entity's economic resources and claims.
In other words, financial reports provide information about an entity's assets (which will generate
economic benefits in future) and liabilities (which will deplete economic benefits in future) in order to
determine the net position (assets minus liabilities) and how that net position changes. Information
about the entity's economic resources and the claims against it helps users to assess the entity's
liquidity and solvency, its needs for additional finance and how successful it is likely to be in obtaining
it.
Definitions
Liquidity. The availability of sufficient funds to meet short-term financial commitments as they fall
due.
Solvency. The availability of cash over the longer term to meet financial commitments as they fall
due.
Changes in an entity's economic resources and claims result from its financial performance and also
from other transactions and events such as the issue of shares or an increase in debt (borrowings).
Information about a reporting entity's financial performance helps users to understand the return
that the entity has produced on its economic resources. This is an indicator of how efficiently and
effectively management has used the resources of the entity and is helpful in predicting future
returns.
Information about an entity's financial performance helps users to assess the entity's past and future
ability to generate net cash inflows from its operations.
Information about a reporting entity's cash flows during a period also helps users assess the entity's
ability to generate future net cash inflows and provides information about factors that may affect its
liquidity or solvency. It also gives users a better understanding of the entity's operations and of its
financing and investing activities.
10 ACCOUNTING REGULATION
Section overview
 Accounting regulation is necessary to reduce subjectivity in producing financial reports and
to increase comparability.
10.1 ACCOUNTING STANDARDS

In an attempt to deal with some of the subjectivity that may occur in producing financial reports and to
achieve comparability between different organisations, accounting standards were developed. These
standards are developed at both a national level (in most countries) and an international level. In this
Study Guide we are concerned with International Accounting Standards (IAS) and International
Financial Reporting Standards (IFRS).
The role of accounting standards is discussed in more detail later in this module.
10.2 ACCOUNTING FOR SITUATIONS WHERE ACCOUNTING

STANDARDS DO NOT EXIST
LO When there is no specific legal regulation or accounting standard which covers an item in the
1.6 accounts, the accountant must make a decision on how this item will be dealt with in the financial
statements. It may be possible to account for the item following the accounting treatment of a similar
item. The accountant may need to make a judgment on the treatment of the item and account for it
so that the financial statements show a true and fair view or a fair presentation of the financial
performance and financial position of the entity.
10.3 USE OF CONCEPTUAL FRAMEWORK

LO A conceptual framework, such as the IASB Conceptual Framework can be beneficial in situations
1.7 where transactions are not covered by an accounting standard. The IASB's Conceptual Framework
includes definitions of the elements of financial statements, i.e. assets, liabilities, equity, income and
expenses, and their recognition criteria. The Conceptual Framework also includes the qualitative
characteristics of financial information – these are the characteristics that financial information should
contain if it is to be useful to users. Therefore, the accountant will have sufficient information
contained within the Conceptual Framework to be able to exercise judgment and decide how to deal
with the transaction in a way that properly represents the underlying transaction.
For example, the accountant can refer to the definitions of assets and liabilities and consider whether
the transaction gives rise to new assets or new liabilities.
In this situation, the Conceptual Framework serves as a useful basis for accountants to refer to when
dealing with transactions not covered by an accounting standard. As the same recognition principles
are included in accounting standards, the outcome should be a consistent method of accounting
regardless of the detail in standards.
11 FUTURE DEVELOPMENTS
Section overview
 The IASB is currently developing a new Conceptual Framework.
MODULE 1
11.1 REVISED FRAMEWORK
The IASB is carrying out a project to develop a new conceptual framework. This project originally
began as part of the process of convergence of IFRS and US GAAP (see earlier in this module).
The IASB has stated that the aim of the project to revise the Framework is to 'create a sound
foundation for future accounting standards that are principles-based, internally consistent and
internationally converged.'
11.2 PROGRESS TO DATE

The current IASB Conceptual Framework for Financial Reporting consists of the original IASB
Framework for the Preparation and Presentation of Financial Statements (originally issued in 1989) with
some chapters replaced by those parts of the new Conceptual Framework that have been finalised.
To date the IASB has finalised chapters on the objectives and qualitative characteristics of financial
statements and has issued an Exposure Draft of a chapter on The Reporting Entity. These chapters
were developed jointly with the US FASB.
The FASB is no longer involved in the project and the IASB is developing the remainder of the new
Conceptual Framework alone.
In July 2013 the IASB issued a Discussion Paper: A Review of the Conceptual Framework for Financial
Reporting. This covers the issues that the IASB/FASB joint project had not yet addressed: definitions
of the elements of financial statements; recognition and derecognition; measurement; and
presentation and disclosure. The IASB does not intend to reconsider the objective of financial
statements or the qualitative characteristics of useful financial information.
Two exposure drafts (ED/2015/3 Conceptual Framework for Financial Reporting and ED/2015/4
Updating References to the Conceptual Framework were published in 2015, and the IASB is to decide
on the project direction during 2016.
12 ACCOUNTING POLICIES
Section overview
 Accounting policies are the specific principles, bases, conventions, rules and practices
adopted by an entity in preparing and presenting financial statements.
 An entity should select accounting policies that provide users of the financial statements
with information that is relevant and reliable in order to ensure that the financial statements
are prepared in accordance with GAAP.
Accounting policies are defined in IAS 8 Accounting Policies, Changes in Accounting Estimates and
Errors.
Definition
Accounting policies are the specific principles, bases, conventions, rules and practices adopted by an
entity in preparing and presenting financial statements.
You will see from this definition that companies have some choice in the matter of accounting policies.
How to apply a particular accounting standard, where a choice exists, is a matter of accounting policy.
How items are presented in the financial statements (including the notes), where alternative
presentations are allowed, is a matter of accounting policy. Policies should be chosen to comply with
IFRS, but with the overriding need for fair presentation.
The first note to a company's financial statements is the disclosure of accounting policies. This may
include the depreciation policy and other issues, such as valuation of inventory or revaluation of non-
current assets.
Another term used is estimation techniques, sometimes called accounting estimates. These involve
the use of judgment when applying accounting policies. For instance, the accounting policy may state
that non-current assets are depreciated over their expected useful life. The decision regarding the
length of useful life is a matter of estimation. The decision regarding method of depreciation is also a
matter of estimation, rather than accounting policy.
There is the further matter of measurement bases. Is the value of the asset, upon which its
depreciation is based, stated at original cost or revalued amount or current replacement cost? This is
the measurement basis and will be stated in the accounting policy. The company must disclose in the
notes to the accounts any change of accounting policy. Any change in measurement basis is
regarded as a change of accounting policy and must be disclosed. Any change in estimation
technique is not a change of accounting policy; however the effects of such a change on the current
and future periods should be disclosed.
12.1 OBJECTIVES IN SELECTING ACCOUNTING POLICIES

In selecting accounting policies, businesses should seek to satisfy two primary criteria: relevance and
reliability. These criteria are characteristics of useful financial information.
The IASB's Conceptual Framework for Financial Reporting uses the terms relevance and faithful
representation. We will look at the characteristics of useful financial information in more detail in the
next module.
12.1.1 RELEVANCE
Appropriate accounting policies will result in the presentation of relevant financial information.
Financial information is relevant if it is:
 capable of influencing the economic decisions of users; and
 provided in time to influence those decisions.
Relevant information possesses either predictive or confirmatory value or both.
12.1.2 FAITHFUL REPRESENTATION

Financial information meets the faithful representation criterion if:
 it reflects the substance of transactions i.e. represents faithfully what has taken place;
 it is free from bias, or is neutral;
 it is free from material error;
 it is complete; and
 prudence (caution) has been applied where there is any uncertainty.
Question 7: Accounting policy
Decide whether or not these represent a change of accounting policy:

(a) The company has previously included certain overheads within cost of sales. It now proposes to
show those overheads within administrative expenses.
(b) A company has previously depreciated vehicles using the reducing balance method at 40 per cent
per year. It now proposes to depreciate vehicles using the straight-line method over five years.
(c) A company has previously measured inventory at weighted average cost. It now proposes to
measure it on a First In, First Out (FIFO) basis.
13 IAS 8 ACCOUNTING POLICIES, CHANGES IN

ACCOUNTING ESTIMATES AND ERRORS
MODULE 1
Section overview
 IAS 8 deals with the treatment of changes in accounting estimates, changes in accounting
policies and errors.
13.1 DEFINITIONS
The following definitions are given in IAS 8:
Definitions
Accounting policies are the specific principles, bases, conventions, rules and practices adopted by an
entity in preparing and presenting financial statements.
A change in accounting estimate is an adjustment of the carrying amount of an asset or a liability or
the amount of the periodic consumption of an asset, that results from the assessment of the present
status of, and expected future benefits and obligations associated with, assets and liabilities. Changes
in accounting estimates result from new information or new developments and, accordingly, are not
corrections of errors.
Material: Omissions or misstatements of items are material if they could, individually or collectively,
influence the economic decisions that users make on the basis of the financial statements. (This is very
similar to the definition in the Conceptual Framework.)
Prior period errors are omissions from, and misstatements in, the entity's financial statements for one
or more prior periods arising from a failure to use, or misuse of, reliable information that:
 was available when financial statements for those periods were authorised for issue; and
 could reasonably be expected to have been obtained and taken into account in the preparation
and presentation of those financial statements.
Such errors include the effects of mathematical mistakes, mistakes in applying accounting policies,
oversights or misinterpretations of facts, and fraud.
Retrospective application is applying a new accounting policy to transactions, other events and
conditions as if that policy had always been applied.
Retrospective restatement is correcting the recognition, measurement and disclosure of amounts of
elements of financial statements as if a prior period error had never occurred.
Prospective application of a change in accounting policy and of recognising the effect of a change in
an accounting estimate, respectively, are:
 applying the new accounting policy to transactions, other events and conditions occurring after the
date as at which the policy is changed; and
 recognising the effect of the change in the accounting estimate in the current and future periods
affected by the change.
Impracticable: Applying a requirement is impracticable when the entity cannot apply it after making
every reasonable effort to do so. It is impracticable to apply a change in an accounting policy
retrospectively or to make a retrospective restatement to correct an error if one of the following apply:
 The effects of the retrospective application or retrospective restatement cannot be determined.
 The retrospective application or retrospective restatement requires assumptions about what
management's intent would have been in that period.
 The retrospective application or retrospective restatement requires significant estimates of

amounts and it is impossible to distinguish objectively information about those estimates that:
– provides evidence of circumstances that existed on the date(s) at which those amounts are to
be recognised, measured or disclosed; and
– would have been available when the financial statements for that prior period were authorised
for issue, from other information.
(IAS 8)
13.2 DETERMINING ACCOUNTING POLICIES

Accounting policies are determined by applying the relevant IFRS and considering any relevant
Implementation Guidance issued by the IASB for that IFRS.
Where there is no applicable IFRS management should use its judgment in developing and applying
an accounting policy that results in information that is relevant and reliable.
Management should refer to:
(a) the requirements of IFRSs dealing with similar and related issues
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities and expenses
in the Conceptual Framework.
Management may also consider the most recent pronouncements of other standard-setting bodies
that use a similar conceptual framework to develop Standards, other accounting literature and
accepted industry practices if these do not conflict with the sources above.
An entity must select and apply its accounting policies for a period consistently for similar
transactions, other events and conditions, unless an IFRS specifically requires or permits categorisation
of items for which different policies may be appropriate. If an IFRS requires or permits categorisation
of items, an appropriate accounting policy must be selected and applied consistently to each
category.
13.3 CHANGES IN ACCOUNTING POLICIES

Changes in accounting policy are normally applied retrospectively.
The same accounting policies are usually adopted from period to period, to allow users to analyse
trends over time in profit, cash flows and financial position. Changes in accounting policy will
therefore be unusual and should be made only if:
(a) the change is required by an IFRS
(b) the change will result in a more relevant and reliable presentation of events or transactions in the
financial statements of the entity.
13.3.1 ADOPTION OF AN IFRS

Where a new IFRS is adopted, IAS 8 requires any transitional provisions in the new IFRS itself to be
followed. If none are given in the IFRS which is being adopted, then the general principles of IAS 8
should be followed.
13.3.2 OTHER CHANGES IN ACCOUNTING POLICY

IAS 8 requires retrospective application, unless it is impracticable to determine the cumulative
amount of change. Any resulting adjustment should be reported as an adjustment to the opening
balance of retained earnings. Comparative information should be restated unless it is impracticable to
do so.
This means that all comparative information must be restated as if the new policy had always been
in force, with amounts relating to earlier periods reflected in an adjustment to opening reserves of the
earliest period presented.
There is one important exception. Where an entity revalues assets for the first time this is treated as
a revaluation under IAS 16 Property, Plant and Equipment, not as a change of accounting policy under
IAS 8. Therefore it is not applied retrospectively.
MODULE 1
If, at the beginning of the current period, it is impracticable to determine the cumulative effect of
applying a new accounting policy to prior periods, the entity should adjust the comparative
information to apply the new accounting policy prospectively only.
13.3.3 DISCLOSURES
Certain disclosures are required when a change in accounting policy has a material effect on the
current period or any prior period presented, or when it may have a material effect in subsequent
periods:
(a) Reasons for the change
(b) Amount of the adjustment for the current period and for each period presented
(c) Amount of the adjustment relating to periods prior to those included in the comparative
information
(d) The fact that comparative information has been restated or that it is impracticable to do so
An entity should also disclose information relevant to assessing the impact of new IFRS on the
financial statements where these have not yet come into force.
Question 8: Change in accounting policy
During the year ended 31 December 20X7 MM Manufacturing decided to change its accounting
policy for inventory valuation from FIFO to weighted average.
Extracts from the financial statements for 20X6 (final) and 20X7 (draft) prior to this change were as
follows:
20X6 20X7 (draft)
$'000 $'000
Sales 50 000 54 000
Cost of goods sold (24 000) (26 000)
Profit before taxes 26 000 28 000
Income taxes (@ 30%) (7 800) (8 400)
Profit for the period 18 200 19 600
The estimated values of MM's inventory under the FIFO and weighted average methods were as
follows:
31/12/X5 31/12/X6 31/12/X7
$'000 $'000 $'000
FIFO 2 800 2 900 2 950
Weighted average 2 700 2 750 2 870
Required
Show the impact of this change of policy on the statement of profit or loss for 20X7, with the 20X6
comparative.
13.4 CHANGES IN ACCOUNTING ESTIMATES

Changes in accounting estimate are not applied retrospectively.
Estimates arise in relation to business activities because of the uncertainties inherent within them.
Judgments are made based on the most up to date information and the use of such estimates is a
necessary part of the preparation of financial statements. It does not undermine their reliability. Here
are some examples of accounting estimates:
(a) A necessary irrecoverable debt allowance
(b) Useful lives of depreciable assets
(c) Provision for obsolescence of inventory
The rule here is that the effect of a change in an accounting estimate should be accounted for
prospectively i.e. it should be included in net profit or loss in either:
(a) the period of the change, if the change affects that period only; or
(b) the period of the change and future periods, if the change affects both.
An example of a change in accounting estimate which affects only the current period is the
irrecoverable debt estimate. However, a revision in the life over which an asset is depreciated would
affect both the current and future periods, in the amount of the depreciation expense.
The effect of a change in an accounting estimate should be included in the same expense
classification as was used previously for the estimate. This rule helps to ensure consistency between
the financial statements of different periods.
The materiality of the change is also relevant. The nature and amount of a change in an accounting
estimate that has a material effect in the current period (or which is expected to have a material effect
in subsequent periods) should be disclosed. If it is not possible to quantify the amount, this
impracticability should be disclosed.
Question 9: Change in accounting estimate
On 1 January 20X3, an asset was purchased by MM Manufacturing for $100 000. It had an estimated
useful economic life of 10 years, and was depreciated on the straight line basis. On 31 December 20X7
a review of non-current assets indicated that the asset would continue to be useable until
31 December 20X9.
Required
Explain the accounting treatment for this asset.
13.5 ERRORS
Material prior period errors must be corrected retrospectively.
Errors discovered during a current period which relate to a prior period may arise through:
(a) mathematical mistakes;
(b) mistakes in the application of accounting policies;
(c) misinterpretation of facts;
(d) oversights; and/or
(e) fraud.
Most of the time these errors can be corrected through net profit or loss for the current period.
Where they are material prior period errors, however, this is not appropriate.
13.5.1 ACCOUNTING TREATMENT

Material prior period errors must be corrected retrospectively.
This involves:
(a) either restating the comparative amounts for the prior period(s) in which the error occurred; or
(b) when the error occurred before the earliest prior period presented, restating the opening balances
of assets, liabilities and equity for that period
MODULE 1
so that the financial statements are presented as if the error had never occurred.
Only where it is impracticable to determine the cumulative effect of an error on prior periods can an
entity correct an error prospectively only.
Various disclosures are required:
(a) the nature of the prior period error;
(b) for each prior period, to the extent practicable, the amount of the correction:
(i) for each financial statement line item affected.
(ii) for basic and diluted earnings per share (if disclosed);
(c) the amount of the correction at the beginning of the earliest prior period presented; and
(d) if retrospective restatement is impracticable for a particular prior period, the circumstances that
led to the existence of that condition and a description of how and from when the error has been
corrected. Subsequent periods need not repeat these disclosures.
Question 10: Error
During 20X7 Global discovered that certain items had been included in inventory at 31 December
20X6, valued at $4.2m, which had in fact been sold before the year end. The following figures for 20X6
(as reported) and 20X7 (draft) are available.
20X6 20X7 (draft)
$'000 $'000
Sales 47 400 67 200
Profit before taxation 12 830 11 400
Income taxes (3 849) (3 420)
Profit for the period 8 981 7 980
Retained earnings at 1 January 20X6 were $13m. The cost of goods sold for 20X7 includes the $4.2m
error in opening inventory. The income tax rate was 30 per cent for 20X6 and 20X7. No dividends have
been declared or paid.
Required
Show the statement of profit or loss and other comprehensive income for 20X7, with the 20X6
comparative, and retained earnings.
CHECKPOINT 2
 A conceptual framework is a statement of generally accepted theoretical principles which form the
frame of reference for financial reporting.
 There are advantages and disadvantages to having a conceptual framework.
 The IASBs Conceptual Framework for Financial Reporting provides the theoretical framework for
the development of IFRS. The Conceptual Framework is being progressively updated by the IASB.
 The Conceptual Framework states that:
'The objective of general purpose financial reporting is 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 IASB is currently developing a new Conceptual Framework.
 Accounting policies are the specific principles, bases, conventions, rules and practices adopted by
an entity in preparing and presenting financial statements.
 An entity should select accounting policies that provide users of the financial statements with
information that is relevant and reliable.
 IAS 8 deals with the treatment of changes in accounting estimates, changes in accounting policies
and errors.
 A change in accounting policy is only allowed where it is required by legislation, by a new
accounting standard or when it will result in more appropriate presentation.
 A change in accounting policy is applied retrospectively.
 A change in accounting estimate is applied prospectively.
 A prior period error is corrected retrospectively.
1 A conceptual framework is
A the proforma financial statements.
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B a list of key terms used by the IASB.
C a theoretical expression of accounting standards.
D a statement of theoretical principles which form the frame of reference for financial reporting.
2 Which of the following is an advantage of a conceptual framework?

A A framework encourages standardised accounting practice.
B The framework does not simplify the preparation and implementation of standards.
C There are a variety of users, so not all will be satisfied with the content of the framework.
D There are a variety of accounting situations which mean flexibility in the accounting approach is
needed.
3 What is the name of the IASB's conceptual framework?

A Statement of Principles for Financial Reporting
B The Conceptual Framework for Financial Reporting
C The Conceptual Framework for the Disclosure of Financial Statements
D The Conceptual Framework for the Presentation of Financial Statements to Users
4 What is the fundamental reason that financial statements are produced, according to the preface
of the IASB's Conceptual Framework?
A to provide information to tax authorities
B to satisfy the requirements of external users
C to provide information for internal management
D to report on a company's performance to its national government
5 Which of the following are uses of financial statements prepared by a company?

I inclusion in national income statistics
II decisions to buy, hold or sell equity investments
III assessment of the security of amounts lent to the entity
IV assessment of management stewardship and accountability
A I and II only
B II and IV only
C III and IV only
D I, II, III and IV
6 According to the Conceptual Framework, who are the most important users of general purpose
financial reports?
A investors and lenders
B investors and employees
C lenders and management
D investors and the government
7 If an accountant comes across a transaction that is not covered by an accounting standard, where
should they look for guidance on accounting for that item?
A UK GAAP
B US GAAP
C company law
D conceptual framework
8 Which of the following constitute a change of accounting policy according to IAS 8 Accounting
Policies, Changes in Accounting Estimates and Errors?
I a change in depreciation method
II a change in the basis of valuing inventory
III adopting an accounting policy for a new type of transaction not previously dealt with
IV a decision to capitalise borrowing costs relating to the construction of non-current assets, rather
than writing them off as incurred
A I and II only
B I and III only
C I and IV only
D II and IV only
9 Which of the following items would qualify for treatment as a change in accounting estimate,
according to IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors?
I provision for obsolescence of inventory
II correction necessitated by a material error
III a change in the useful life of a non-current asset
IV a change as a result of the adoption of a new International Accounting Standard
A I and III only

B I and IV only
C II and III only
D I, II, III and IV
14 THE ROLE OF ACCOUNTING STANDARDS
Section overview
 There are two different approaches to developing accounting standards: principles-based,
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and rules based. Principles-based standards are developed according to a set of laid down
principles. Rules-based standards regulate for issues as they arise. Both these approaches
have advantages and disadvantages.
 Accounting standards are authoritative statements of how particular types of transactions
and other events should be reflected in the financial statements.
14.1 SUBJECT OUTLINE

LO The next few sections of this module will examine the purpose of accounting standards as the means
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of setting out the accounting rules to be followed. First, we will discuss the two different methods of
setting accounting rules, the principles-based and rules-based approaches and then look at the role of
accounting standards in more detail.
14.2 PRINCIPLES-BASED VERSUS RULES-BASED SYSTEMS

A principles-based system works within a set of defined principles. A rules-based system regulates for
issues as they arise. Both of these have advantages and disadvantages.
The IASB's Conceptual Framework for Financial Reporting is intended to provide the underlying
principles within which standards can be developed. One of the main purposes of a conceptual
framework is to ensure that standards are not produced which are in conflict with each other. In
addition, any departure from a standard can be judged on the basis of whether or not it is in keeping
with the principles set out in the Conceptual Framework. A principles-based system of accounting is
a system which is based on a conceptual framework.
The opposite of a principles based system is a rules-based system, in which there are a number of
detailed regulations designed to cover every eventuality.
In practice, most standard setting bodies, including the IASB, have developed or adopted standards
that are a mixture of principles and rules. IFRS can currently be viewed as a 'hybrid' system: there is a
conceptual framework and many standards are principles-based, but some standards (mainly those
influenced by US GAAP) are rules-based.
14.3 THE DIFFERENCES BETWEEN A PRINCIPLES-BASED SYSTEM AND A

RULES-BASED SYSTEM
A rules-based system requires preparers to understand and apply detailed rules to report specific
transactions.
A principles-based system requires preparers to use judgment in order to develop accounting
policies to report specific types of transactions and events.
Consider accounting for tangible non-current assets. An extreme rules-based approach would set out
precise requirements for each type of asset, for example:
'Plant and equipment should be depreciated on the straight line basis over a period not exceeding
four years.'
A principles-based approach would contain more general requirements, for example:
'The depreciable amount of an asset shall be allocated on a systematic basis over its useful
life…The depreciation method used shall reflect the pattern in which the asset's future economic
benefits are expected to be consumed by the entity.' (IAS 16 Property, Plant and Equipment)
Rules-based accounting standards often need to contain complex definitions and scope exceptions.
For example, if plant and equipment must be depreciated over four years, while other classes of asset
are depreciable over a longer period, the standard must define what is meant by plant and
equipment. Standards often contain further material that explains and interprets the rules and this in
turn may be supplemented by guidance and regulations relating to particular industries or types of
transaction. As a result, accounting standards and guidance can be voluminous.
A purely rules-based system has the following advantages:
 in theory, it results in financial statements being comparable between entities (or between entities
in the same industry);
 it may reduce the volume of explanation necessary in financial statements (as in theory there is
only one allowed accounting treatment for each type of transaction or event);
 it is suitable for large, complex economies (such as the US); and
 it provides the 'answers' in almost all situations; preparers do not have to make judgments and
risk the consequences (e.g. litigation or reputational damage if a user makes a wrong decision
based on information in the financial statements).
Principles-based accounting standards are likely to be less lengthy and complex than rules-based
standards, with fewer definitions and scope exceptions.
There may be an explicit requirement that the financial statements show a 'true and fair view' of the
entity's financial performance and financial position and that this requirement should override all
others. An entity may depart from a requirement if management is convinced that this is necessary
(normally in exceptional circumstances).
Standards normally require very full disclosure of information about the nature of transactions or
events and the accounting policies adopted. This is seen as necessary in order for users to understand
the information that is being presented in the financial statements and to make meaningful
comparisons between different entities.
In practice, principles based standards often need to be accompanied or supported by explanatory
material, illustrative examples, and interpretations. The IASB has a separate operating body that
issues interpretations of standards where interpretation difficulties arise, while the Australian
Accounting Standards Board appoints Interpretation Advisory Panels on an ad hoc basis.
A purely or mainly principles-based system has the following advantages:
 in theory, it is more likely than a rigid-rules based system to result in financial statements that show
a true and fair view/give a fair presentation;
 it encourages the use of professional judgment;
 it is less open to 'creative accounting' abuses as principles are harder to evade than rules; and
 arguably it is more flexible than a system of rules and can therefore cope better with a rapidly
changing business and economic environment.
See also the advantages of a conceptual framework we covered earlier in this module; many of these
also apply here.
Question 11: What type of standard?
There are two main types of lease: operating lease and finance lease. The way in which a lease is
classified can have a significant impact on the financial statements.
Below are some extracts from a fictional accounting standard that explains how a lease should be
classified:
Where a lease transfers substantially all of the risks and benefits associated with owning the asset to
the lessee, the lease is a finance lease. Where the lessor retains substantially all the risks and benefits
associated with owning the asset, the lease is an operating lease.
A lease is normally presumed to be a finance lease if, at the beginning of the lease term, the present
value of the minimum lease payments is 90 per cent or more of the fair value of the leased asset at
that date.
(a) What type of standard is this, rules-based or principles-based?

(b) Explain why the requirements above might reduce the usefulness of the information in the financial
statements. (You are not required to discuss accounting for leases in your answer.)
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14.4 THE PURPOSE OF ACCOUNTING STANDARDS
Definition
Accounting standards. Accounting standards are authoritative statements of how particular types of
transactions and other events should be reflected in the financial statements.
Accounting standards form part of the Generally Accepted Accounting Principles (GAAP) that sets out
the accounting rules that companies must abide by. They are structured to provide detailed guidance
on accounting for a particular item. For example, there are a number of accounting standards that
deal with the accounting treatment of items recognised in the financial statements such as non-current
assets, provisions and liabilities.
Accounting standards are of key importance in the regulation process as they provide the detailed rules
on dealing with transactions and disclosures in the financial statements. Without this detailed guidance,
companies would be free to account for transactions as they wished, which would firstly reduce the
comparability of financial statements and secondly, could lead to misleading accounts if companies
report transactions in a more favourable light. Neither of these options would be beneficial to users of
the financial statements.
In many countries, including Australia, accounting standards have the force of law. Some or all limited
liability companies are required to comply with them in preparing financial statements. Listing
authorities also require compliance with standards as a condition of obtaining a stock exchange
listing. In some countries, including Australia and the UK, some not for profit entities and
governmental organisations may also be required to comply with accounting standards.
Even where compliance is not an actual legal requirement (for example, for a small or unincorporated
entity) the requirements of accounting standards are normally taken to represent 'best practice'.
14.4.1 ACCOUNTING STANDARDS AND THE CONCEPTUAL FRAMEWORK

We have already seen that a conceptual framework exists to provide a basis for the preparation of
financial statements. In theory, accounting standards should be consistent with the principles of the
conceptual framework. For example, any accounting standard dealing with the recognition of assets
should include the definition of an asset from the conceptual framework as well as the relevant
recognition criteria.
One of the stated purposes of the IASB's Conceptual Framework is to assist in applying IFRS. Where
there is no accounting standard covering a particular transaction, the Conceptual Framework can be
used to assist in developing an appropriate accounting treatment.
14.4.2 ACCOUNTING STANDARDS AND A FAIR PRESENTATION

The objective of financial statements is to provide information about the financial position and
performance of an entity. Financial information should show a fair presentation or true and fair view
of the activities of an entity.
Like 'true and fair view', 'present fairly' is not defined in the Conceptual Framework or in any IFRS.
However, IAS 1 Presentation of Financial Statements explains that:
 Fair presentation requires the faithful representation of the effects of transactions, other events
and conditions in accordance with the definitions and recognition criteria for assets, liabilities,
income and expenses set out in the Conceptual Framework.
 Compliance with IFRS, with additional disclosure where necessary, is presumed to result in
financial statements that achieve a fair presentation.
We will examine the meaning of faithful representation later in this module.
The following points made by IAS 1 expand on this principle:
(a) If an entity has complied with IFRS, it should disclose that fact in its financial statements.
(b) All relevant IFRS must be followed if compliance with IFRS is disclosed.
(c) Use of an inappropriate accounting treatment cannot be rectified either by disclosure of
accounting policies or notes/explanatory material.
Fair presentation involves more than mere compliance. Preparers should apply the 'spirit' (or general
intention) behind an accounting standard as well as the strict 'letter'. The requirement to 'present
fairly' also applies to transactions which are not covered by any specific accounting standard.
Fair presentation requires an entity to:
 select and apply appropriate accounting policies;
 present information in a manner that results in relevant, reliable, comparable and understandable
information; and
 provide additional disclosures where these are necessary to enable users to understand the
impact of particular transactions, other events and conditions on an entity's financial performance
and position.
IAS 1 states that disclosure (explanatory material or notes) does not rectify inappropriate
accounting policies.
15 ACCOUNTING STANDARDS AND CHOICE
Section overview
 There are arguments for and against having accounting standards.
It is sometimes argued that having accounting standards actually reduces the quality of financial
reporting, and that individual companies should be given more choice over how they report
transactions. There are arguments on both sides.
Many of the advantages and disadvantages of accounting standards are similar to the advantages and
disadvantages of accounting regulation in general which we covered earlier in this module.
15.1 ADVANTAGES OF ACCOUNTING STANDARDS

Standards have the following advantages:
 They reduce or eliminate confusing variations in the methods used to prepare accounts and so
increase the usefulness of financial information. Users of financial statements need to be able to
compare an entity's financial performance and position with those of other, similar entities. They
also need to be able to compare the performance and position of an entity over time, in order to
evaluate trends. (For example, have sales increased or decreased compared with those of the
previous period?)
 They make it more difficult for preparers to adopt accounting treatments that deliberately
mislead users. Without accounting standards management could adopt the accounting
treatments that produced the highest reported profit and the strongest financial position possible,
even if these did not give a fair presentation.
 They provide guidance to preparers of financial statements. The business environment is
becoming increasingly complex and some preparers may find it difficult to determine the
appropriate accounting treatment for many types of transaction or event (for example, those
involving derivative financial instruments or arrangements whose economic substance is not the
same as their legal form).
 Financial statements prepared in accordance with accounting standards are based on generally
accepted accounting practice and arguably this makes them more understandable than they
would otherwise be.
 They generally improve the quality of general purpose financial reporting. Standards require
entities to disclose more accounting information than they would otherwise have done if
standards did not exist. This information includes the accounting policies used in the preparation
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of the financial statements. As well as increasing the amount of information that is available, in
theory, standards help to ensure that the financial statements actually do provide relevant
information that users need.
 They provide a focal point for debate and discussions about accounting practice and in that way
contribute to the development of best practice.
 They are a means of reaching a consensus about the way in which particular items should be
treated. The development of IFRS involves a full consultative process in which users and preparers
are able to be directly involved.
 They are a less rigid alternative to enforcing conformity by means of legislation.
 They improve the credibility of financial reporting generally. Users are more likely to trust financial
information if it has been prepared in accordance with accounting standards and other regulation
than if they would be if standards did not exist.
15.2 DISADVANTAGES OF ACCOUNTING STANDARDS

The disadvantages of accounting standards are as follows:
 Not all entities are the same size or operate in the same industry. An accounting treatment that is
appropriate for some entities may not be appropriate for others. The use of an inappropriate
accounting treatment may actually reduce the quality of the information provided.
 The development of accounting standards and other regulation is a political process and may be
affected by lobbying or government pressure. Although anyone can comment on a proposed
standard, most commentators tend to be large listed companies or large professional firms:
organisations with considerable power to influence standard setters in their own interests.
 Most recent standards have been developed to meet the needs of providers of capital to large
public companies. For many smaller entities, the cost of complying (both in time and money)
outweigh the benefits to users.
 Accounting standards do not always prevent preparers from manipulating the figures. Some
preparers view them as a set of rules that they can evade through 'creative accounting'. (This is
less likely if standards are based on principles and concepts rather than detailed rules.)
 Earlier standards were not based on a conceptual framework of accounting. This means that they
may be inconsistent with one another. The IASB is committed to rectifying this.
 There may be a trend towards rigidity, and away from flexibility in applying the rules. Some
commentators believe that preparers should be free to use their professional judgment on
technical matters.
 Accounting standards often require extensive disclosure. It can be argued that this makes
financial statements harder to understand and less useful.
 Accounting standards may have unforeseen economic consequences for the entities who have to
apply them and for others and may affect the commercial decisions taken by management. For
example, a company might avoid particular actions (such as investment in certain types of asset)
that might benefit it in the long term, if they were required to treat the transactions in a way that
dramatically reduced reported profit.
Case study: Economic consequences
The UK standard FRS 17 Accounting for Retirement Benefits changed the financial reporting treatment
of some types of pension scheme (defined benefit schemes). This had the effect of significantly
increasing the non-current liabilities of the companies that operated those schemes. As a result, most
companies which operated defined benefit schemes closed them to new entrants and replaced them
with pension arrangements that were much less advantageous to their employees.
It has been argued that accounting standards should reflect economic reality (e.g. companies that
operate defined benefit schemes have a liability for the cost of providing pensions in future periods)
and standard setters should not concern themselves with the possible consequences of requiring a
particular accounting treatment. Recently, however, following the global economic crisis, a few
commentators and politicians have begun to question this.
16 ACCOUNTING CONCEPTS
Section overview
 Going concern is an underlying assumption in preparing financial statements. It is the main
underlying assumption stated in the Conceptual Framework.
 Financial information (other than information about cash flows) should be prepared on an
accruals basis.
16.1 GOING CONCERN

Definition
Going concern. The entity is normally viewed as a going concern, that is, as continuing 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. (Conceptual Framework)
This concept assumes that, when preparing a normal set of accounts, the business will continue to
operate in approximately the same manner for the foreseeable future (at least the next 12 months).
In particular, the entity will not go into liquidation or scale down its operations in a material way.
The main significance of a business being a going concern is that:
1 Assets should not be measured at their 'break-up' value that is the amount they would sell for if
they were sold off piecemeal and the business was broken up (unless the assets satisfy the
requirements of IFRS 5 Non-current Assets Held for Sale and Discontinued Operations). If assets
are classified as held for sale in accordance with IFRS 5, they should be measured at the lower of
carrying amount and fair value less costs to sell.
2 Liabilities are classified as current or non-current depending on when they are due to be settled.
16.1.1 EXAMPLE: GOING CONCERN

Emma acquires a T-shirt printing machine at a cost of $60 000. The asset has an estimated life of six
years with a scrap value of nil at the end of six years, and it is normal to write off the cost of the asset
to the statement of profit or loss over this time. In this case a depreciation cost of $10 000 per year is
charged.
Using the going concern assumption, it is presumed that the business will continue its operations and
so the asset will produce economic benefits throughout its full six years in use. A depreciation charge
of $10 000 is made each year, and the value of the asset in the statement of financial position is its cost
less the accumulated depreciation charged to date. After one year, the carrying amount of the asset
is $(60 000 – 10 000) = $50 000, after 2 years it is $40 000, after 3 years $30 000 and so on, until it is
written down to a value of 0 after 6 years.
This asset has no other operational use outside the business and, in a forced sale, it would only sell for
scrap. After one year of operation, its scrap value is $8000.
The carrying amount of the asset, applying the going concern assumption, is $50 000 after 1 year, but
its immediate sell-off value only $8000. It can be argued that the asset is over-valued at $50 000, that it
should be written down to its break-up value ($8000) and the balance of its cost should be treated as
an expense. However, provided that the going concern assumption is valid, it is appropriate
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accounting practice to value the asset at its carrying amount.
Question 12: Going concern
A retailer commences business on 1 January and buys inventory of 20 washing machines, each costing
$100. During the year he sells 17 machines at $150 each. How should the remaining machines be
valued at 31 December in the following circumstances?
(a) He is forced to close down his business at the end of the year and the remaining machines will
realise only $60 each in a forced sale.
(b) He intends to continue his business into the next year.
If the going concern assumption is not followed, that fact must be disclosed, together with the
following information:
(a) the basis on which the financial statements have been prepared; and
(b) the reasons why the entity is not considered to be a going concern.
16.2 ACCRUALS BASIS OF ACCOUNTING

Definition
In the accruals basis of accounting, items are recognised as assets, liabilities, equity, income and
expenses (the elements of financial statements) when they satisfy the definitions and recognition
criteria for those elements in the Conceptual Framework. (IAS 1)
Entities should prepare their financial statements on the basis that transactions are recorded in them,
not as the cash is paid or received, but as the revenues or expenses are earned or incurred in the
accounting period to which they relate.
According to the accruals assumption, profit is computed as the surplus/(deficit) of revenue and
expenses. In computing profit, revenue earned must be matched against the expenditure incurred in
earning it. This is also known as the matching convention.
16.2.1 EXAMPLE: ACCRUALS

Emma prints 20 T-shirts in her first month of trading (May) at a cost of $5 each (purchased on credit
terms). She then sells all of them for $10 each. Emma has therefore made a profit of $100, the surplus
of revenue ($200) earned over the cost ($100) of acquiring them.
If, however, Emma only sells 18 T-shirts, it is incorrect to charge her statement of profit or loss (income
statement) with the cost of 20 T-shirts, as she still has 2 T-shirts in inventory. If she sells them in June,
she is likely to make a profit on the sale. Therefore, the profit is $90, the surplus of sales revenue ($180)
over the purchase cost of 18 T-shirts ($90).
Her statement of financial position will look like this.

$
Assets
Inventory (at cost, i.e. 2 × $5) 10
Accounts receivable (18 × $10) 180
190
Capital and liabilities
Proprietor's capital (profit for the period: 18 × $5) 90
Accounts payable (20 × $5) 100
190
However, if Emma had decided to give up selling T-shirts, then the going concern assumption no
longer applies and the value of the 2 T-shirts in the statement of financial position is break-up
valuation, not cost. Similarly, if the 2 unsold T-shirts are unlikely to be sold at more than their cost of $5
each (say, because of damage or a fall in demand) then they should be recorded on the statement of
financial position at their net realisable value (i.e. the likely eventual sales price less any expenses
incurred to make them saleable, i.e. say, $4 each) rather than cost. This shows the application of the
prudence concept, which we will discuss shortly.
In this example, the concepts of going concern and accruals are linked. Since the business is assumed
to be a going concern, it is possible to carry forward the cost of the unsold T-shirts as a charge against
profits of the next period.
16.3 SUBSTANCE OVER FORM

Faithful representation of a transaction is only possible if it is accounted for according to its substance
and economic reality, not solely based on its legal form.
Definition
Substance over form. The principle that transactions and other events are accounted for and
presented in accordance with their substance and economic reality and not merely their legal form.
For instance, one party may sell an asset to another party and the sales documentation may record
that legal ownership has been transferred. However, if agreements exist whereby the party selling the
asset continues to enjoy the future economic benefits arising from the asset, then in substance no sale
has taken place.
An example of substance over form is found in accounting for finance leases. A finance lease is one
in which the risks and rewards of ownership are transferred to the lessee (the party who physically
holds the asset). In a finance lease arrangement, the lessee never obtains legal title to the asset so
does not own that asset. However, they have all the risks and rewards of ownership, such as the right
to use the asset for most, if not all, of its useful life and they must bear the costs of ownership such as
insurance and maintenance. For this reason, the asset is capitalised in the lessee's accounts and
treated as an owned asset, following the substance of the transaction. This accounting treatment will
ensure that the financial statements show the true financial position of the entity, and does not hide
assets and liabilities from the statement of financial position.
In accounting for the finance lease above, if the legal form was followed, the asset and the finance
lease liability would not be recognised which would make the financial statements look better than
they actually are. This has the effect of improving the gearing ratio, as the liability is not recorded, it
also improves the return on capital employed, as the asset base is lower. Hence following substance
over form is key in showing a fair presentation of the financial statements of an entity.
Case study: Repo 105
After the investment bank, Lehman Brothers, collapsed in 2008 it was discovered that the bank had
used a transaction known as 'Repo 105' to raise short term finance. Financial assets were swapped for
cash but with an agreement to buy them back at a future date. The substance of this transaction is that
the 'seller' continues to control the asset, so it remains in the statement of financial position. The
obligation to redeem for cash is recorded as a liability.
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However, Lehman Brothers transferred assets worth 105 per cent of the cash it received in return.
Because of this, under the rules in US GAAP it was able to record the transaction as a sale on the
grounds that technically it had lost control of the assets and no longer owned them. Therefore the
cash received was recorded as an asset rather than a liability. The bank's liabilities were significantly
understated and it was able to mislead investors and lenders about its true financial position.
17 QUALITATIVE CHARACTERISTICS OF FINANCIAL

INFORMATION
Section overview
 Qualitative characteristics are the attributes that make the information provided in financial
statements useful to users.
 The two fundamental qualitative characteristics are: relevance and faithful representation.
 The four enhancing qualitative characteristics are: comparability, verifiability, timeliness and
understandability.
LO
The IASB's Conceptual Framework for Financial Reporting sets out and explains the qualitative
1.6
characteristics of useful financial information.
There are two fundamental qualitative characteristics: relevance and faithful representation.
Information must be possess these characteristics in order to be useful.
There are four enhancing qualitative characteristics: comparability, verifiability, timeliness and
understandability. These qualities enhance the usefulness of financial information.
17.1 RELEVANCE
Relevant financial information has predictive value, confirmatory value, or both.
Definition
Relevance. Relevant financial information is capable of making a difference in the decisions made by
users. (Conceptual Framework)
Information on financial position and performance is often used to predict future position and
performance and other things of interest to the user, e.g. likely dividend, wage rises. Financial
information is also used to confirm (or change) users' past conclusions about an entity's financial
performance or financial position.
Information can have both predictive value and confirmatory value. For example, revenue for the
current year can be used to predict revenue for next year. Actual revenue for the current year can also
be compared with expected revenue that was predicted using last year's financial statements.
17.1.1 MATERIALITY
The relevance of information is affected by its materiality.
Definition
Materiality. Information is material if omitting it or misstating it could influence decisions that users
make on the basis of financial information about a specific reporting entity. (Conceptual Framework)
The Conceptual Framework explains that materiality is entity-specific. It depends on the nature or size
(or both) of items taken in the context of an individual entity's financial report.
Information may be judged relevant simply because of its nature, even though the amounts involved
may be small in relation to the financial statements as a whole (e.g. remuneration of management). In
other cases, both the nature and materiality of the information are important. Materiality is not a
primary qualitative characteristic itself because it is merely a threshold or cut-off point.
17.2 FAITHFUL REPRESENTATION

To be useful, financial information must faithfully represent the economic events that it purports to
represent. The user must be able to depend on it being a faithful representation.
Definitions
Faithful representation. A faithful representation is complete, neutral and free from error.
A complete depiction includes all the information necessary for a user to understand the
phenomenon being depicted, including all necessary descriptions and explanations.
A neutral depiction is without bias in the selection or presentation of financial information. This means
that information must not be manipulated in any way in order to influence the decisions of users.
Free from error means there are no errors or omissions in the description of the phenomenon and no
errors made in the process by which the financial information was produced. It does not mean that no
inaccuracies can arise, particularly where estimates have to be made. (Conceptual Framework)
17.3 COMPARABILITY
Comparability is the qualitative characteristic that enables users to identify and understand similarities
in, and differences among, items. Information about a reporting entity is more useful if it can be
compared with similar information about other entities and with similar information about the same
entity for another period or another date.
The consistency of treatment is therefore important across like items over time, within the entity and
across all entities.
The disclosure of accounting policies is particularly important here. Users must be able to
distinguish between different accounting policies in order to be able to make a valid comparison of
similar items in the accounts of different entities.
Comparability is not the same as uniformity i.e. items need not be identical in order to be
comparable. For information to be comparable, like things must look alike and different things must
look different, Comparability is not enhanced by making unlike items look alike. Therefore entities
should change accounting policies if they become inappropriate.
Corresponding information for preceding periods should be shown to enable comparison over time.
17.4 VERIFIABILITY
Verifiability helps assure users that information faithfully represents the economic events it purports to
represent.
Verifiability means that different knowledgeable and independent observers could reach consensus
(not necessarily complete agreement) that a particular depiction is a faithful representation.
17.5 TIMELINESS
Timeliness means having information available to users in time to be capable of influencing their
decisions.
Generally, the older the information is, the less useful it is. However, older financial information may
still be useful for identifying and assessing trends (for example, growth in profits over a number of
years).
MODULE 1
17.6 UNDERSTANDABILITY
Classifying, characterising and presenting information clearly and concisely makes it understandable.
Some information is inherently complex and difficult to understand. Excluding this information from
the financial statements would make them more understandable, but they would also be incomplete
and potentially misleading.
Financial reports are prepared for users who have a reasonable knowledge of business and economic
activities and who review and analyse the information diligently. Users may sometimes need to seek
help from an adviser in order to understand information about complex economic events.
17.7 APPLYING THE QUALITATIVE CHARACTERISTICS

Information must be both relevant and faithfully represented if it is to be useful. In practice, an entity
must often find a balance between the two, with the aim of presenting the most relevant information
that can be faithfully represented.
A faithful representation, by itself, does not necessarily result in useful information. Suppose that an
entity receives a government grant to purchase an asset. The asset has no cost to the entity and
therefore is not recognised in the statement of financial position. This is a faithful representation of the
transaction, but users of the financial statements are not aware that the entity has the asset. They have
been deprived of useful and relevant information.
The same principle applies to the enhancing qualitative characteristics. Sometimes, one characteristic
may have to be diminished in order to maximise another. For example, applying a new standard may
reduce comparability in the short term, but may improve relevance or faithful representation in the
longer term.
17.8 THE COST CONSTRAINT ON USEFUL FINANCIAL REPORTING

Cost is a pervasive constraint on the information that can be provided by financial reporting. The
Conceptual Framework explains that it is important that the costs of reporting financial information
are justified by the benefits.
The IASB takes this into account when developing standards. It considers costs and benefits in relation
to financial reporting generally, not just in relation to individual entities. Different reporting
requirements for different reporting entities may be appropriate in some circumstances. For example,
the IASB has recently developed a special standard for small and medium sized entities.
18 INTERNATIONAL FINANCIAL REPORTING

STANDARDS
Section overview
 There are currently 16 IFRS in issue, as well as several International Accounting Standards
(IAS).
 IFRS are having a growing influence on national accounting requirements and practices.
 Where a company has to change from a national GAAP to IFRS, it has to deal with a
number of practical issues.
18.1 STANDARDS CURRENTLY IN ISSUE

The current list of International Accounting Standards and International Financial Reporting Standards
is as follows:
DATE OF
INTERNATIONAL ACCOUNTING STANDARDS
ISSUE
IAS 1 (revised) Presentation of Financial Statements Jun 2011
IAS 2 Inventories Dec 2003
IAS 7 Statement of Cash Flows Dec 1992
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors Dec 2003
IAS 10 Events after the Reporting Period Dec 2003
IAS 11 Construction Contracts Dec 1993
IAS 12 Income Taxes Nov 2000
IAS 16 Property, Plant and Equipment Dec 2003
IAS 17 Leases Dec 2003
IAS 18 Revenue Dec 1993
IAS 19 Employee Benefits
(revised) Jun 2011
IAS 20 Accounting for Government Grants and Disclosure of Government Assistance Jan 1995
IAS 21 The Effects of Changes in Foreign Exchange Rates Dec 2003
IAS 23 Borrowing Costs
(revised) Jan 2008
IAS 24 Related Party Disclosures
(revised) Nov 2009
IAS 26 Accounting and Reporting by Retirement Benefit Plans Jan 1995
IAS 27 Consolidated and Separate Financial Statements
(revised) May 2011
IAS 28 Investments in Associates and Joint Ventures
(revised) May 2011
IAS 29 Financial Reporting in Hyperinflationary Economies Jan 1995
IAS 32 Financial Instruments: Presentation Dec 2003
IAS 33 Earnings per Share Dec 2003
IAS 34 Interim Financial Reporting Feb 1998
IAS 36 Impairment of Assets Mar 2004
IAS 37 Provisions, Contingent Liabilities and Contingent Assets Sep 1998
IAS 38 Intangible Assets Mar 2004
IAS 39 Financial Instruments: Recognition and Measurement Dec 2003
IAS 40 Investment Property Dec 2003
IAS 41 Agriculture Feb 2001
DATE OF EFFECTIVE
INTERNATIONAL FINANCIAL REPORTING STANDARDS
ISSUE DATE
IFRS 1 (revised) First time Adoption of International Financial Reporting Nov 2008 1 Jul 2009
Standards
IFRS 2 Share-based Payment Feb 2004 1 Jan 2005
MODULE 1
IFRS 3 (revised) Business Combinations Jan 2008 1 Jul 2009
IFRS 4 Insurance Contracts Mar 2004 1 Jan 2005
IFRS 5 Non-current Assets Held for Sale and Discontinued Operations Mar 2004 1 Jan 2005
IFRS 6 Exploration for and Evaluation of Mineral Resources Dec 2004 1 Jan 2006
IFRS 7 Financial Instruments: Disclosures Aug 2005 1 Jan 2007
IFRS 8 Operating Segments Nov 2006 1 Jan 2009
IFRS 9 Financial Instruments Nov 2013 1 Jan 2018
IFRS 10 Consolidated Financial Statements May 2011 1 Jan 2013
IFRS 11 Joint Arrangements May 2011 1 Jan 2013
IFRS 12 Disclosure of Interests in Other Entities May 2011 1 Jan 2013
IFRS 13 Fair Value Measurement May 2011 1 Jan 2013
IFRS 14 Regulatory Deferral Accounts Jan 2014 1 Jan 2016
IFRS 15 Revenue from Contracts with Customers May 2014 1 Jan 2018
IFRS 16 Leases Jan 2016 1 Jan 2019
IFRS for SMEs International Financial Reporting Standard for Small and Jul 2009
Medium sized Entities
18.2 SCOPE AND APPLICATION OF IFRS

18.2.1 SCOPE
Any limitation of the applicability of a specific IFRS is made clear within that standard. IFRS are not
intended to be applied to immaterial items. An item is immaterial if its omission or misstatement
would not influence decisions that users of financial statements make. Each individual IFRS lays out its
scope at the beginning of the standard.
18.2.2 APPLICATION
Within each individual country local regulations govern, to varying degrees, the issue of financial
statements. These local regulations include accounting standards issued by the national regulatory
bodies and/or professional accountancy bodies in the country concerned.
18.3 ALTERNATIVE TREATMENTS

Many of the old standards permitted two accounting treatments for like transactions or events. One
treatment was designated as the benchmark treatment (effectively the preferred treatment) and the
other was known as the alternative treatment. This is no longer the case. However, some standards do
still allow more than one policy – for instance, IAS 16 allows property, plant and equipment to be carried at
cost or revalued amount.
18.4 INTERPRETATION OF IFRS

The IFRS Interpretations Committee (as discussed earlier in this module) has the responsibility for
issuing additional guidance on the application of an accounting standard where unsatisfactory or
conflicting interpretations exist. The documents issued are called IFRICs. As at October 2016, there
are 21 IFRICs in issue (of which 13 are still in force), together with 32 SICs (of which 27 have been
superseded) which were issued by the IFRS Interpretations Committee's predecessor, the Standing
Interpretations Committee.
The IFRS Interpretations Committee may also suggest IASB agenda items if there are financial
reporting issues that are not specifically covered by an IFRS.
18.5 FAIR PRESENTATION OVERRIDE

There may be (very rare) circumstances when management decides that compliance with a
requirement of an IFRS would be misleading. Departure from the IFRS is therefore required to
achieve a fair presentation. IAS 1 Presentation of Financial Statements states that the following should
be disclosed in such an event:
(a) management confirmation that the financial statements fairly present the entity's financial position,
performance and cash flows;
(b) a statement that all IFRS have been complied with except departure from one IFRS to achieve a fair
presentation;
(c) details of the nature of the departure, why the IFRS treatment would be misleading, and the
treatment adopted; or
(d) financial impact of the departure.
This is sometimes referred to as the 'true and fair override' or the 'fair presentation' override. Not
all jurisdictions allow the use of the 'true and fair' override. For example, in Australia, preparers of
financial statements are not permitted to depart from any of the requirements of accounting
standards (see section 6.10). Instead, the financial statements must disclose additional information.
18.6 EXTREME CASE DISCLOSURES

In very rare circumstances, management may conclude that compliance with a requirement in a
Standard or Interpretation may be so misleading that it would conflict with the objective of financial
statements set out in the Conceptual Framework, but the relevant regulatory framework prohibits
departure from the requirements. IAS 1 states that in such cases the entity needs to reduce the
perceived misleading aspects of compliance by disclosing:
(a) the title of the Standard, the nature of the requirement and the reason why management has
reached its conclusion
(b) for each period, the adjustment to each item in the financial statements that would be necessary to
achieve fair presentation.
18.7 WORLDWIDE EFFECT OF IFRS AND THE IASB

The IASB, and before it the IASC, has now been in existence for around 40 years, and it is worthwhile
considering the effect it has had in that time.
As far as Europe is concerned, the consolidated financial statements of many of Europe's top
multinationals are now prepared in conformity with national requirements, European Commission (EC)
directives and IFRS. Furthermore, IFRS are having a growing influence on national accounting
requirements and practices. Many of these developments have been given added impetus by the
internationalisation of capital markets.
Australia has wholly adopted IFRS and issues Australian Equivalent International Financial Reporting
Standards (AIFRS). The AASB adopted IFRS for annual reporting periods for companies from
1 January 2005. This means that all general financial purpose statements prepared by for-profit
entities prepared in accordance with AASB are also in accordance with IFRS.
In 2006, China officially released a new set of Chinese Accounting Standards (CASs) which are
substantially converged with IFRSs, and reaffirmed its commitment to international convergence.
In 2005, the IASB and the Accounting Standards Board of Japan (ASBJ) announced a joint project to
reduce differences between IFRSs and Japanese accounting standards. Since 2010, Japanese listed
companies meeting certain criteria have been permitted to use IFRSs as designated by The Financial
Services Agency of Japan. Consultation is also underway on the use of IFRSs in Japan.
Until recently, the US was one of the few countries in which IFRS financial statements were not
accepted. However, over the last 10 years the US authorities have moved significantly closer to
recognising IFRS, although it is unlikely that the US will adopt IFRSs in the near future. Convergence of
IFRS and US GAAP was discussed earlier when we introduced the Norwalk Agreement, and is
discussed in more detail in the following section.
18.8 EFFECT OF HARMONISATION ON COMPANIES
MODULE 1
There are two main ways in which an individual country can harmonise its national GAAP with IFRS. It
can require some or all entities (usually listed companies) to comply with IFRS from a particular date.
Alternatively, it can converge its domestic standards with IFRS over a period of time, typically in
stages. Obviously, the effect on individual companies is less dramatic and easier to manage if
countries choose the second of these routes to harmonisation.
Where a company has to change from a national GAAP to IFRS on a particular date it has to deal with
a number of practical issues. Typically, the main issues are as follows:
(a) Management, internal accounts staff and auditors need to be fully trained in IFRS. While there may
be broad similarities between domestic standards and IFRS, there are frequently numerous
differences in the detail.
(b) Accounting systems and information systems may need to be upgraded to deal with more
complex or different reporting requirements.
(c) It is important to communicate with stakeholders (particularly investors, lenders and their advisors)
to prepare them for the possible effect of the change on the entity's reported results and financial
position.
(d) The change to IFRS affects reported profits and net assets. Management remuneration may
depend on a certain level of profits or on increases in profits. Debt covenants (agreements with
lenders) may depend on a company maintaining a key level of assets to liabilities, or debt to
equity. Remuneration schemes and debt covenants may need to be re-negotiated.
(e) IFRS disclosure requirements may be far more onerous than those of national GAAP. Preparers
need to make sure that they have all the necessary information, bearing in mind that they will need
to present at least one set of comparative figures under IFRS, as well as the figures for the current
year.
(f) It may still be necessary to prepare accounts under national GAAP for the tax authorities.
A 2009 AASB publication IFRS Adoption in Australia summarised the outcomes of the change to IFRS
from 2005. The benefits have been:
 Australian entities' financial reports are more readily understood world wide;
 there are synergies in the preparation, audit and analysis of Australian financial reports for entities
that are part of a multinational group; and
 improved reporting of financial instruments (an area in which IFRS was more comprehensive than
Australian GAAP).
The disadvantages have been:
 the initial costs of adoption, particularly for banks and insurers in implementing the standards on
financial instruments;
 the pace of change: companies have had to deal with numerous amendments to IFRS that are
often driven by issues that are not a concern in Australia; and
 accounting and reporting issues that are important to Australian companies (for example, for
extractive industries) are not a priority for the IASB.
Case study: Reporting under IFRS
When companies adopt IFRS for the first time, they are required to include a reconciliation between
profit after tax as previously reported and profit after tax under IFRS.
An extract from the financial statements of a retail group for the year ended 31 December 2005 (the
first full year of applying IFRS) is shown below. The reconciliation statement is for the year ended
31 December 2004 (the previous year).
(b) Reconciliation of profit after tax between AGAAP (Australian Generally Accepted Accounting
Principles) and AIFRS.
Consolidated Parent Company
31 Dec 04 31 Dec 04
$million $million
Profit after tax attributed to Members as previously reported under 832.9 347.7
AGAAP
Investment property revaluations (1) 2,298.1 –
Minority interest property revaluations (1) (141.2) –
Investment property revaluations attributable to equity accounted
associates (1) 462.2 –
Deferred tax charge (1) (358.4) (29.0)
Goodwill on acquisitions (due to the recognition of deferred tax
liabilities) written off (1) (460.0) –
Other AIFRS adjustments (3.2) (0.2)
Profit after tax attributable to members under AIFRS 2,630.4 318.5
(1)
AASB 10 'Investment Property' requires revaluation increment/decrement to be recognised through
the income statement. Under AGAAP revaluation movements were recognised in the asset revaluation
reserve.
Profit for the year is significantly higher under IFRS than under Australian GAAP (AGAAP). This is
because of the effect of IFRS on the group's investment properties (see the note to the statement). At
this time, property prices were steadily rising.
Below is shown another reconciliation statement, this time from the financial statements of a
telecommunications and media company for the year ended 30 June 2005 (this company's first full
year of reporting under IFRS was the year to 30 June 2006). This company is in a different business
from the retail group and the effect of adopting IFRS is not as pronounced. There is no one significant
item, but a number of differences and the overall effect is to reduce profit for the year by $129 million
(or by just under 3 per cent).
MODULE 1
19 DEVELOPMENTS IN INTERNATIONAL
HARMONISATION
Section overview
 Although the IASB has faced criticism and political pressures, there is broad general
support for its overall objective of implementing a single set of high quality, global financial
reporting standards.
Arguably, the development of high quality International Financial Reporting Standards has been a
major factor in making international harmonisation possible. International standards have to be
perceived as at least as good as, or preferably better than, the national GAAP that they replace,
otherwise they will not be accepted by the world's major stock exchanges.
This section looks at the progress that has been made towards harmonisation and the obstacles that
still remain.
19.1 THE IASB AND IOSCO

The International Organisation of Securities Commissions (IOSCO) is the representative of the world's
securities markets' regulators. High quality information is vital for the operation of an efficient capital
market, and differences in the quality of the accounting policies and their enforcement between
countries leads to inefficiencies between markets. IOSCO has been active in encouraging and
promoting the improvement and quality of IFRS over the last 15 years. This commitment was
evidenced by the agreement between the International Accounting Standards Committee (IASC) (the
predecessor of the IASB) and IOSCO to work on a program of 'core standards' which could be used
by publicly listed entities when offering securities in foreign jurisdictions.
The 'core standards' project resulted in fifteen new or revised IFRS and was completed in 1999 with
the issue of IAS 39 Financial Instruments: Recognition and Measurement. IOSCO spent a year
reviewing the results of the project and released a report in May 2000 which recommended to all its
members that they allow multinational issuers to use IFRS, as supplemented by reconciliation,
disclosure and interpretation where necessary to address outstanding substantive issues at a national
or regional level.
IASB staff and IOSCO continue to work together to resolve outstanding issues and to identify areas
where new IASB standards are needed.
19.2 POLITICAL PROBLEMS

Any international body, whatever its purpose or activity, faces enormous political difficulties in
attempting to gain international consensus and the IASB is no exception to this. How can the IASB
reconcile the financial reporting situation between economies as diverse as third-world developing
countries and sophisticated first-world industrial powers?
Developing countries are suspicious of the IASB, believing it to be dominated by the US. This arises
because acceptance by the US listing authority, the Securities and Exchange Commission (SEC), of
IFRS has been seen as a major hurdle to be overcome. For all practical purposes it is the American
market which must be persuaded to accept IFRS and we discussed this earlier in this module when we
briefly looked at the Norwalk Agreement. Developing countries have been catered for to some extent
by the issue of a Standard on agriculture, which is generally of much more relevance to such
countries.
There are also tensions between the UK/US model of financial reporting and the European model.
The UK/US model is based around investor reporting, whereas the European model is mainly
concerned with tax rules, so shareholder reporting has a much lower priority.
Although the EU countries have now adopted IFRS for the consolidated financial statements of listed
entities, the Regulation actually requires listed companies to adopt the standards and Interpretations
that have been endorsed by the European Financial Reporting Advisory Group (EFRAG). Many
have feared that in practice this might lead to EFRAG effectively becoming a European standard
setting body and that eventually Europe might adopt its own variant of IFRS. This has not
happened. However, fair value accounting for financial instruments has been a very controversial
issue. The hedge accounting provisions of IAS 39 Financial Instruments: Recognition and
Measurement have still not been fully endorsed.
The global financial crisis of 2008 intensified the above problems. Because IFRS requires most
financial assets to be measured at fair value, entities had to record huge losses on remeasurement
when share prices fell. Many argued that the IASB had contributed to the crisis by requiring the use
of fair values (sometimes called 'mark to market' accounting). Some politicians, particularly within
Europe, began to press the IASB to amend its financial instruments standards urgently so that
companies would not have to recognise changes in the fair value of financial instruments in profit or
loss. The IASB responded by accelerating its project to develop a new standard on financial
instruments (due to come into force in 2018) but has not retreated from its basic position, i.e. that
most financial assets should be measured at fair value.
Many also voiced general criticisms of the IASB and the IFRS Foundation:
(a) it was not publicly accountable;
(b) its operating procedures were not sufficiently transparent and did not allow enough consultation;
and
(c) it continued to be dominated by US interests and has prioritised convergence to US GAAP at the
expense of other projects.
The IASB has responded to these criticisms by making some changes in its constitution and operating
MODULE 1
procedures. These include the following:
(a) A Monitoring Board has been set up to provide a formal link between the Trustees and public
capital market authorities. The role of the Monitoring Board was described earlier in this module.
(b) The composition of the IASB board has changed. Originally, the IASB board had 14 members, of
which 12 were full time and 2 were part time. Although most developed countries were
represented, in practice over half the members came from North America. The IASB now has 12
members. As before, the members are appointed on the basis of their experience and technical
expertise and are selected so that there is a mix of auditors, preparers of financial statements,
users of financial statements and academics. Currently, there are three members from the
Asia/Oceania region; three members from Europe; two members from North America; one
member from Africa; one member from South America; and two members appointed from any
area, subject to maintaining overall geographical balance.
(c) Three-yearly public consultations on the IASB's technical agenda have been introduced. The most
recent of these consultations took place in 2015 and the results were announced on
2 November 2016. The IASB has taken account of these results in drawing up its current work
program.
(d) A provision for accelerated due process has been introduced for use in exceptional circumstances.
Despite the criticisms, there is still broad general support for the IASB's overall objective of
implementing a single set of high quality, global financial reporting standards.
19.3 THE EUROPEAN COMMISSION (EC) REGULATION

As we have already seen, the EC regulations form one part of a broader program for the
harmonisation of company law in member states. The Commission is uniquely the only organisation to
produce international standards of accounting practice that are legally enforceable, in the form of
directives that must be included in the national legislation of member states. The directives have been
criticised as they might become constraints on the application of world-wide standards and bring
accounting standardisation and harmonisation into the political arena.
The EC adopted a regulation stating that from 2005 consolidated accounts of listed companies are
required to comply with IFRS. The implications of this are far reaching.
Many commentators believe that, in the light of the above, it is only a matter of time before national
standard-setting bodies are, in effect, replaced by the IASB and national standards fall into disuse.
However, national standards were designed for the national environment, which may include small
companies, the not-for-profit private sector and/or the public sector. Moreover, the IASB will need
input and expertise from valued national standard-setters.
19.4 CONVERGENCE WITH US GAAP

Since 2002 there have been a variety of attempts to increase convergence of International and US
accounting standards. Some standards have been issued jointly by the IASB and FASB, and since 2007
Companies listed on US stock exchanges but filing financial statements under IFRSs have not been
required to prepare a reconciliation to US GAAP. However pressure within the US accounting
community means that there is unlikely to be a move to IFRSs in the near future.
As discussed earlier in this module, in October 2004 the IASB and FASB agreed to develop a common
conceptual framework which would be a significant step towards harmonisation of future standards.
Several chapters were released, but the remainder of the new Conceptual Framework will be
developed by the IASB alone.
19.5 DIALOGUE WITH OTHER KEY STANDARD-SETTERS

The IASB maintains a policy of dialogue with other key standard-setters around the world, in the
interest of harmonising standards across the globe.
National standard-setters are often involved in the development of Discussion Papers and Exposure
Drafts on new areas. To ensure international representation, both the members of the IASB and the
Trustees of the IFRS Foundation are to be taken from a broad geographical range which is specified:
six from Asia/Oceania; six from Europe; six from North America; one from Africa; one from South
America; and two from the rest of the world.
In addition, in 2013 the IFRS Foundation set up a new body, the Accounting Standards Advisory
Forum (ASAF). This consists of national accounting standard setters and regional bodies with an
interest in financial reporting. The purpose of the group is to provide technical advice and feedback to
the IASB. The 12 members of the ASAF are chosen to ensure a broad geographical representation
and balance of the major economic regions of the world and include the US FASB, the Australian
Accounting Standards Board (AASB) and the UK Financial Reporting Council, as well as the standard-
setting bodies from China and Japan and the Asian-Oceanian Standard Setters Group. The IFRS
Trustees review membership of ASAF every two years.
19.6 THE SITUATION TODAY AND IN THE FUTURE

Many organisations committed to global harmonisation have done a great deal of work towards this
goal. It is the case at present, however, that some disagreements still exist between countries and
organisations about the way forward. One of the major inconsistencies is between the reporting
requirements in developed countries and those in non-developed countries. It will be some time
before these difficulties can be overcome. The IASB is likely to be the lead body in attempting to do
so, as discussed above.
CHECKPOINT 3
 A principles-based system works within a set of laid down principles. A rules-based system
regulates for issues as they arise. Both of these have advantages and disadvantages.
 There are arguments for and against having accounting standards.
MODULE 1
 Going concern is an underlying assumption in preparing financial statements.
 Financial information (other than information about cash flows) should be prepared on the accruals
basis.
 Qualitative characteristics are the attributes that make the information provided in financial
statements useful to users.
 The two fundamental qualitative characteristics are: relevance and faithful representation.
 The four enhancing qualitative characteristics are: comparability, verifiability, timeliness and
understandability.
 Although the IASB has faced criticism and political pressures, there is broad general support for its
overall objective of implementing a single set of high quality, global financial reporting standards.
1 Which of the following is an advantage of a principles based system of accounting standard

setting?
A It always provides the answers.
B It discourages creative accounting.
C It results in greater comparability of financial statements.
D It needs to be supported by illustrative examples and interpretations.
2 Which of the following statements are correct?

I Application of IFRS is presumed to result in financial statements that achieve a fair presentation.
II Under IFRS, all published financial statements are required to present fairly the financial
position and financial performance of an entity.
A I only
B II only
C both I and II
D neither I nor II
3 Which of the following statements represents a disadvantage of the use of accounting standards?
A Standards are a less rigid alternative to legislation.
B Standards may tend towards rigidity in applying the rules.
C Standards oblige companies to disclose their accounting policies.
D Standards reduce variations in methods used to produce accounts.
4 According to the Conceptual Framework, which of the following is the underlying assumption
relating to financial statements?
A The information is free from material error or bias.
B The accounts have been prepared on an accruals basis.
C The business is expected to continue in operation for the foreseeable future.
D Users are assumed to have sufficient knowledge to be able to understand the financial
statements.
5 There are four enhancing qualitative characteristics of useful financial information. What are those
characteristics?
A going concern, accruals, completeness, verifiability
B comparability, timeliness, verifiability, understandability
C substance over form, neutrality, going concern, accruals
D comparability, understandability, completeness, neutrality
6 Listed below are some comments on accounting concepts and useful financial information:
I Materiality means that only items having a physical existence may be recognised as assets.
II A faithful representation of financial information can never include amounts based on estimates.
III Financial information prepared using accrual accounting provides a better basis for assessing an
entity's performance than information based only on cash flows.
Which, if any, of these comments is correct, according to the IASB's Conceptual Framework for
Financial Reporting?
A I only
B II only
C III only
D none of the above
7 What is the accounting concept called that requires income and expenses to be matched in the
period in which they occur, rather than when the cash is received or paid?
A accruals
B neutrality
C materiality
D faithful representation
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8 How many IFRS have been published by the IASB (excluding the IFRS for SMEs)?
A 16
B 29
C 41
D 43
9 Which of the following is a benefit of harmonisation?

A increased training of staff to deal with new accounting standards
B ability of investors to compare cross border financial statements
C amendment of tax systems in different countries to align with accounting requirements
D different countries have different legal systems for accounting which need to be amended
10 With which accounting body has the IASB carried out a joint project to develop several common
accounting standards?
A the OECD
B the Standards Advisory Council
C the Financial Accounting Standards Board
D the Australian Accounting Standards Board
20 THE ELEMENTS OF FINANCIAL STATEMENTS
Section overview
 Transactions and other events are grouped together in broad classes and in this way their
financial effects are shown in the financial statements. These broad classes are the
elements of financial statements.
20.1 SUBJECT OUTLINE

Earlier in this module, we discussed the principles of the IASB's Conceptual Framework for Financial
Reporting. This section looks at some of the detail within the Conceptual Framework and examines
the definitions of the elements of financial statements.
LO
The Conceptual Framework sets out these elements as follows:
1.6
Elements of financial
statements
Measurement of Measurement of
financial position in performance in the
the statement of statement of profit or
financial position loss and other
comprehensive income
• Assets • Income
• Liabilities • Expenses
• Equity
A process of sub-classification then takes place for presentation in the financial statements, e.g.
assets are classified by their nature or function in the business to show information in the best way for
users to make economic decisions.
20.2 FINANCIAL POSITION

We need to define the three terms listed under this heading above.
Definitions
Asset. A resource controlled by an entity as a result of past events and from which future economic
LO benefits are expected to flow to the entity.
1.6
Liability. 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.
Equity. The residual interest in the assets of the entity after deducting all its liabilities.
(Conceptual Framework)
These definitions are important, but they do not cover the criteria for recognition of any of these
items, which are discussed in the next section of this module. This means that the definitions may
include items which would not actually be recognised in the statement of financial position because
they fail to satisfy recognition criteria particularly, as we will see below, the probable flow of any
economic benefit to or from the business.
Whether an item satisfies any of the definitions above will depend on the substance and economic
MODULE 1
reality of the transaction, not merely its legal form as discussed earlier.
20.3 ASSETS
We can look in more detail at the components of the definitions given above.
Definition
Future economic benefit. The potential to contribute, directly or indirectly, to the flow of cash and
cash equivalents to the entity. The potential may be a productive one that is 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 cost
of production. (Conceptual Framework)
Assets are usually employed to produce goods or services for customers; customers will then pay for
these, so resulting in future economic benefit.
The existence of an asset, particularly in terms of control, is not reliant on:
(a) physical form (hence patents and copyrights are assets); nor
(b) legal rights (hence leases can give rise to assets).
Transactions or events in the past give rise to assets; those expected to occur in the future do not in
themselves give rise to assets. For example, an intention to purchase a non-current asset does not, in
itself, meet the definition of an asset.
20.4 LIABILITIES
Again we can look more closely at some aspects of the definition. An essential characteristic of a
liability is that the entity has a present obligation.
Definition
Obligation. A duty or responsibility to act or perform in a certain way. Obligations may be legally
enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise,
however, from normal business practice, custom and a desire to maintain good business relations or
act in an equitable manner. (Conceptual Framework)
It is important to distinguish between a present obligation and a future commitment. A management

decision to purchase assets in the future does not, in itself, give rise to a present obligation. An
obligation is something that cannot be avoided.
Settlement of a present obligation will involve the entity giving up resources embodying economic
benefits in order to satisfy the claim of the other party. This may be done in various ways, not just by
payment of cash.
Liabilities must arise from past transactions or events. For example, in the recognition of future
rebates to customers based on annual purchases, the sale of goods in the past is the transaction that
gives rise to the liability.
20.4.1 PROVISIONS
Companies may include provisions, for example for legal damages or warranty obligations, in their
financial statements. Is a provision a liability?
Definition
Provision. A present obligation which satisfies the rest of the definition of a liability, even if the
amount of the obligation has to be estimated. (Conceptual Framework)
Question 13: Asset or liability?
Consider the following situations. In each case, does the company have an asset or liability within the
definitions given by the Conceptual Framework? Give reasons for your answer.
(a) Pat Co has purchased a patent for $20 000. The patent gives the company sole use of a particular
manufacturing process which will save $3000 a year for the next 5 years.
(b) Baldwin Co paid a mechanic $10 000 to set up a car repair shop, on condition that priority
treatment is given to cars from the company's fleet.
(c) Deals on Wheels Co provides a warranty with every car sold.
20.5 EQUITY
LO Equity is defined above as a residual, but it may be sub-classified in the statement of financial position
4.2.3 into different equity reserves. The amount shown for equity depends on the measurement of assets
and liabilities. This is discussed in more detail later in this module.
20.6 FINANCIAL PERFORMANCE

Profit is used as a measure of performance, or as a basis for other measures (e.g. earnings per share).
It depends directly on the measurement of income and expenses, which in turn depend (in part) on
the concepts of capital (the amount invested in a business by its owners) and capital maintenance
adopted (see Module 2).
The elements of income and expenses are therefore defined.
Definitions
Income. Increases in economic benefits during the accounting period in the form of inflows or
LO enhancements of assets or decreases of liabilities that result in increases in equity, other than those
1.6 relating to contributions from equity participants.
Expenses. Decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurring of liabilities that result in decreases in equity, other than those
relating to distributions to equity participants. (Conceptual Framework)
Income and expenses can be presented in different ways in the financial statements to provide
information relevant for economic decision-making. For example, a distinction is made between
income and expenses which relate to continuing operations and those which do not.
20.7 INCOME
LO Both revenue and gains are included in the definition of income. Revenue arises in the course of
1.6 ordinary activities of an entity.
Definition
Gains. Increases in economic benefits. As such they are no different in nature from revenue.
Gains include those arising on the disposal of non-current assets. The definition of income also
includes unrealised gains, e.g. on revaluation of marketable securities. These are gains which have
not yet been realised because the securities have not yet been sold at the increased price.
20.8 EXPENSES
LO As with income, the definition of expenses includes losses as well as those expenses that arise in the
MODULE 1
1.6 course of ordinary activities of an entity.
Definition
Losses. Decreases in economic benefits. As such they are no different in nature from other expenses.
Losses will include those arising on the disposal of non-current assets. The definition of expenses will
also include unrealised losses, e.g. downward revaluation of property, unrealised because the
property has not been sold at the reduced value.
20.9 CAPITAL MAINTENANCE ADJUSTMENTS

Definition
Capital maintenance adjustments. The revaluation or restatement of assets and liabilities gives rise
to increases or decreases in equity. (Conceptual Framework)
IFRSs allow or require certain assets to be measured at fair value in the financial statements. Such
assets are remeasured periodically in accordance with the requirements of relevant IFRS, to ensure
that an up to date fair value is reflected.
This periodic revaluation, or restatement, of an asset's carrying amount may be either upwards or
downwards, so resulting in either a gain (income) or a loss (expense).
The gain or loss is not included in an entity's profit or loss for the year under certain concepts of
capital maintenance. Instead it is shown as 'other comprehensive income'. Other comprehensive
income includes items of income or expense which are not permitted to be included in profit or loss
for the year, but which do meet the definition of income and expenses and result in an increase or
decrease in equity.
21 RECOGNITION OF THE ELEMENTS OF FINANCIAL

STATEMENTS
Section overview
 Items which meet the definition of assets or liabilities may still not be recognised in financial
statements because they must also meet certain recognition criteria.
Definition
Recognition. The process of incorporating into the statement of financial position or statement of
LO profit or loss and other comprehensive income an item that meets the definition of an element and
1.6 satisfies the following criteria for recognition:
(a) it is probable that any future economic benefit associated with the item will flow to or from the
entity; and
(b) the item has a cost or value that can be measured with reliability. (Conceptual Framework)
Regard must also be given to materiality as defined in the Conceptual Framework.
Definition
Materiality. Information is material if omitting it or misstating it could influence decisions that users
make on the basis of financial information about a specific reporting entity. (Conceptual Framework)
21.1 PROBABILITY OF FUTURE ECONOMIC BENEFITS

Probability here means the degree of uncertainty that the future economic benefits associated with
an item will flow to or from the entity. This must be judged on the basis of the characteristics of the
entity's environment and the evidence available when the financial statements are prepared.
21.2 RELIABILITY OF MEASUREMENT

The cost or value of an item, in many cases, must be estimated. The Conceptual Framework states,
however, that the use of reasonable estimates is an essential part of the preparation of financial
statements and does not undermine their reliability. Where no reasonable estimate can be made, the
item should not be recognised, although its existence should be disclosed in the notes, or other
explanatory material.
Items may still qualify for recognition at a later date due to changes in circumstances or subsequent
events.
21.3 RECOGNITION OF ITEMS

LO We can summarise the recognition criteria for assets, liabilities, income and expenses, based on the
1.6 definition of recognition given above.
ITEM RECOGNISED IN WHEN
Asset The statement of financial It is probable that the future economic benefits will flow to the
position entity and the asset has a cost or value that can be measured
reliably.
Liability The statement of financial It is probable that an outflow of resources embodying
position economic benefits will result from the settlement of a present
obligation and the amount at which the settlement will take
place can be measured reliably.
ITEM RECOGNISED IN WHEN

Income The statement of profit or loss An increase in future economic benefits related to an increase
and other comprehensive in an asset or a decrease of a liability has arisen that can be
income measured reliably, other than those relating to contributions
from equity participants
Expenses The statement of profit or loss A decrease in future economic benefits related to a decrease
and other comprehensive in an asset or an increase of a liability has arisen that can be
MODULE 1
income measured reliably, other than those relating to distributions to
equity participants
22 APPLYING THE RECOGNITION CRITERIA
Section overview
 The Conceptual Framework for Financial Reporting sets out criteria that should be applied
in determining whether to recognise assets, liabilities, equity, income or expenses in the
financial statements.
22.1 ASSETS
LO The Conceptual Framework explains that an asset is not recognised in the statement of financial
1.6 position when expenditure has been incurred but it is considered not probable that economic
benefits will flow to the entity beyond the current accounting period. Instead, an expense is
recognised.
Consider the case of advertising expenditure. The company incurs the cost of having its products and
services advertised because management believes that increased sales revenue will result. It could be
argued that the advertising meets the definition of an asset: it is a resource controlled by the entity as
the result of a past transaction (the contract with the agency and the payment of the fee) and
economic benefit is expected to flow to the entity as a result (in the form of increased sales revenue).
But the cost of the advertising cannot be capitalised (recognised as an asset), because it fails at least
one and probably both of the recognition criteria:
 It is certainly possible that the entity will obtain economic benefit from the expenditure in a future
period, but it would normally be quite difficult to argue that an increase in revenue is probable.
Even if there is a pattern of increased sales following an advertising campaign, it would be very
difficult to prove that a certain number of customers bought a particular product or a service just
because they had seen an advert for it (although that may have been a factor, possibly a
subconscious one, in their decision).
 In the same way, it would be very difficult to prove that X amount of advertising expenditure
resulted in Y amount of additional sales revenue. Therefore the 'asset' does not have a cost that
can be measured reliably.
Question 14: Research and development expenditure
Below is an extract from the annual report of a retail group.

Significant Accounting Policies
Research and development
Expenditure on research activities, undertaken with the prospect of gaining new technical knowledge
and understanding, is recognised in the profit and loss as an expense as incurred.
Expenditure on development activities, whereby research findings are applied to a plan or design for
the production of new or substantially improved products and processes, is capitalised if the product
or process is technically and commercially feasible and the consolidated entity has sufficient resources
to complete development. The expenditure capitalised includes the cost of materials, direct labour
and an appropriate proportion of overheads.
Other development expenditure is recognised in the income statement as an expense as incurred.

Capitalised development expenditure is stated at cost less accumulated amortisation and impairment
losses.
Required
Explain the reasoning behind these accounting policies.
22.2 LIABILITIES
LO A liability is recognised in the statement of financial position when
1.6
(a) it is probable that an outflow of resources embodying economic benefits will result from the
settlement of a present obligation; and
(b) the amount at which the liability will be settled can be measured reliably.
There are two considerations here: deciding whether an outflow is probable; and estimating the
amount of the liability.
Consider a possible liability arising from a claim against a company. One of its customers has been
seriously injured, allegedly as the result of buying and using the company's products. For there to be a
liability, there must be a present obligation to pay damages as a result of a past event (the purchase
and use of the products). At the year-end, lawyers advise that there is approximately an 80 per cent
chance that the company will be found liable. It is more likely than not that the company will have to
pay compensation, which will amount to between $50 000 and $100 000.
In this case, there is a liability and it meets the first of the recognition criteria: it is probable that there
will be an outflow of economic benefit. Because the lawyers have been able to determine a range of
possible outcomes the second recognition criteria is met: the amount of the liability can be measured
reliably.
The company recognises a provision (a liability of uncertain timing or amount) for the best estimate
of the amount to settle the obligation.
Question 15: Legal claim
A customer is making a claim against a company. At the year-end, the company's lawyers advise that
there is approximately a 40 per cent chance that the company will be found liable and will have to pay
compensation.
Explain how you would treat the claim in the financial statements for the period.
22.3 EQUITY
LO The Conceptual Framework defines equity as the residual interest in the assets of the entity after
1.6 deducting all its liabilities. This is a restatement of the basic accounting equation:
ASSETS – LIABILITIES = EQUITY
Equity consists of funds contributed by shareholders (share capital), retained earnings and other
reserves. Other reserves are normally appropriations of retained earnings.
Equity can be viewed as a type of liability: the amount owed to the equity shareholders (its owners).
However, there is a crucial difference between equity and liabilities. For there to be a liability there
must be an obligation: an outflow of economic benefits that cannot realistically be avoided.
Many companies are financed by a mixture of equity and debt (borrowings).
 Debt finance is a liability of the company. The company will eventually have an obligation to
repay the amount. In almost all cases, the company also has an obligation to pay interest on its
debt, regardless of the amount of the entity's profits or losses. There is normally reasonable
certainty about the amount that the lenders will receive and about when they will receive it.
 Equity shares give their holders the right to share in the company's profit and losses and (in
theory) to influence the policies adopted by management by exercising voting rights. They are
exposed to the risks and uncertainties of the business. The return on their investment (in the form
of dividends) depends on the company's results; in a poor year they may receive nothing. If the
company is wound up, they may receive a share of its retained profits, but only after the lenders
and other creditors have been paid.
MODULE 1
During the last thirty years there has been a growth in the number and complexity of types of financial
instrument. For legal reasons, some instruments are called shares although they have the
characteristics of debt. Preparers of financial statements should look at the economic substance of the
arrangement in order to decide whether a financial instrument is debt (a liability) or equity.
Question 16: Preference shares
A company has two classes of shares: ordinary shares and 6 per cent redeemable preference shares
which were issued at $1 each. Holders of the preference shares receive a dividend of 6 per cent of the
amount of their shareholding each year. For example, a shareholder who held 10 000 preference
shares would automatically receive a dividend of $600 each year, regardless of the company's
performance. The preference shares mature in five years' time: at that date the capital that the holders
have invested will be repaid to them.
Are the preference shares part of equity, or a liability? Explain your answer.
22.4 INCOME
LO The Conceptual Framework explains that income is recognised when
1.6
(a) there has been an increase in future economic benefits related to an increase in an asset or a
decrease of a liability; and
(b) this increase or decrease can be measured reliably.
For example, when an entity makes a sale it recognises revenue and it also recognises an asset: cash
or an amount receivable that will eventually be converted into cash. This asset meets the recognition
criteria:
 it is probable that there will be an inflow of economic benefit (cash has either already been
received or will be received in the near future); and
 the amount can be reliably measured (it is normally a matter of fact and can be verified).
Similarly, when an entity recognises a gain on disposal of an asset it also recognises a net increase in
assets: tangible assets decrease, but cash increases by a greater amount.
Determining when to recognise revenue can sometimes be a problem. Even a simple sales transaction
has several stages: the customer orders the goods; the goods are produced; the goods are delivered
to the customer; the customer is invoiced; and the cash is received. In theory, a company could argue
a case for recognising a sale at any of these stages, but generally accepted accounting practice is to
recognise the revenue when the goods are despatched to the customer. This is the critical event in
the earnings cycle. At this point the company has performed its side of the sales contract with the
customer and has earned the right to payment.
Some sales transactions are more complicated than this. It is necessary to apply the recognition
criteria and to determine the economic substance of the transaction. This may involve determining
whether or not
(a) the entity has transferred the significant risks and rewards of ownership of the goods to the
buyer; or
(b) the entity has any continuing managerial involvement or control over the goods sold.
When it is a service that is sold, revenue is recognised as or when the service is performed. For
example, revenue from a magazine subscription is recognised over the period of the subscription.
In recent years, there have been several occasions on which companies have adopted controversial
accounting policies for revenue recognition (sometimes called 'aggressive earnings management').
These controversial policies have all involved recognising revenue before it has actually been earned.
Question 17: Airline
Below is an extract from the annual report of an international airline group

Statement of significant accounting policies: Revenue Recognition
Passenger, Freight and Tours and Travel Revenue
Passenger, freight and tours and travel revenue is recognised when passengers or freight are uplifted
or when tours and travel air tickets and land content are utilised. Unused tickets are recognised as
revenue using estimates based on the terms and conditions of the ticket.
Explain the reasoning behind this accounting policy, applying the recognition criteria in the
Conceptual Framework.
22.5 EXPENSES
LO The Conceptual Framework explains that expenses are recognised when
1.6
(a) there has been a decrease in future economic benefits related to a decrease in an asset or an
increase in a liability; and
(b) this increase or decrease can be measured reliably.
For example, when an entity incurs office expenses such as light and heat it recognises the expense
and it also recognises a liability: the amount payable to the supplier. This liability meets the
recognition criteria:
 it is probable that there will be an outflow of economic benefits (the entity must eventually pay the
amount it owes to the supplier); and
 the amount can be reliably measured (the amount payable will either have been invoiced or can be
estimated based on past experience).
Expenses are recognised in profit or loss on the basis of a direct association between the costs
incurred and the earning of specific items of income (the matching of costs and revenues). Applying
the matching concept should not result in the recognition of items in the statement of financial
position that do not meet the definition of assets or liabilities.
Where economic benefits are expected to arise over several accounting periods, expenses are
allocated to accounting periods in a systematic and rational way. For example, property, plant and
equipment is depreciated in order to match the expense of acquiring it to the income which it
generates. The expense is recognised in the accounting periods in which the economic benefits
associated with it are consumed.
When expenditure produces no future economic benefits an expense should be recognised
immediately in profit or loss. An expense is also recognised when a liability is incurred without the
recognition of an asset.
Question 18: Restoration costs
A mining company is legally obliged to restore the site and to rectify environmental damage after
each mine is closed. Typically, a mine is expected to operate for at least 20 years. Approximately 40
per cent of the eventual expense relates to the removal of mineshafts and the rectification of damage
that occurs when the mine is originally sunk, the remainder of the cost relates to damage that is
caused progressively as the minerals are extracted.
During the current reporting period the company has sunk a mineshaft but not yet commenced
extracting minerals.
According to the Conceptual Framework, how should this event be reported in the financial
statements for the current period and subsequent periods?
23 THE MAIN FINANCIAL STATEMENTS
MODULE 1
Section overview
 The principal financial statements of a business are the statement of financial position
and the statement of profit or loss and other comprehensive income.
23.1 STATEMENT OF FINANCIAL POSITION

Definition
The statement of financial position is simply a list of all the assets owned and/or controlled and all
the liabilities owed by a business as at a particular date. It is a snapshot of the financial position of the
business at a particular moment. Monetary amounts are attributed to each of the assets and liabilities.
23.1.1 ASSETS
Examples of assets are factories, office buildings, warehouses, delivery vans, lorries, plant and
machinery, computer equipment, office furniture, amounts owing from customers (receivables), cash
and goods held in store awaiting sale to customers.
Some assets are held and used in operations for a long time. An office building is occupied by
administrative staff for years; similarly, a machine has a productive life of many years before it wears
out. These types of assets are called non-current assets.
Other assets are held for only a short time. The owner of a newspaper shop, for example, has to sell
his newspapers on the same day that he gets them. The more quickly a business can sell the goods it
has in store, the more profit it is likely to make; provided, of course, that the goods are sold at a
higher price than what it cost the business to acquire them. These are current assets.
Current/non-current distinction
An entity must present current and non-current assets as separate classifications on the face of the
statement of financial position.
23.1.2 LIABILITIES
Examples of liabilities are amounts owed to a supplier for goods purchased on credit, amounts owed
to a bank (or other lender), a bank overdraft and amounts owed to tax authorities (e.g. in respect of
sales tax/GST).
Some liabilities are due to be paid fairly quickly e.g. amounts payable to suppliers. Other liabilities
may take some years to repay (e.g. a bank loan).
Current/non-current distinction
The categorisation of current liabilities is very similar to that of current assets.
23.1.3 CAPITAL OR EQUITY

The amounts invested in a business by the owner, together with the retained profits of the business,
are amounts that the business owes to the owner. These are known as capital or equity. In a limited
liability company, capital introduced usually takes the form of shares. Equity may be thought of as the
owner's stake in the net assets of the business, but note that this would only be paid to the owner (less
liquidation costs) in the unlikely event of the business winding up.
23.1.4 FORM OF STATEMENT OF FINANCIAL POSITION

A statement of financial position may also be called a balance sheet. This name is appropriate
because assets will always be equal to liabilities plus equity. An example of a statement of financial
position for a company is shown below.
XYZ – STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER
20X7 20X6
Assets $'000 $'000
Non-current assets
Property, plant and equipment 450 850 470 790
Goodwill 80 800 91 200
Other intangible assets 227 470 227 470
Financial assets 142 500 156 000
901 620 945 460
Current assets
Inventories 135 230 132 500
Trade receivables 91 600 110 800
Other current assets 25 650 12 540
Cash and cash equivalents 312 400 322 900
564 880 578 740
Total assets 1 466 500 1 524 200
Equity and liabilities
Share capital 650 000 600 000
Retained earnings 313 550 210 300
Other components of equity 10 200 21 200
Total equity 973 750 831 500
Non-current liabilities
Long-term borrowings 120 000 160 000
Deferred tax 28 800 26 040
Long-term provisions 28 850 52 240
Total non-current liabilities 177 650 238 280
Current liabilities
Trade and other payables 115 100 187 620
Short-term borrowings 150 000 200 000
Current portion of long-term borrowings 10 000 20 000
Current tax payable 35 000 42 000
Short-term provisions 5 000 4 800
Total current liabilities 315 100 454 420
Total liabilities 492 750 692 700
Total equity and liabilities 1 466 500 1 524 200
Case study: Statement of financial position

The consolidated statement of financial position of Wesfarmers Ltd Group at 30 June 2012 is shown
below. This is presented in a different order from the illustration above, but notice that it still clearly
shows the three elements defined in the Conceptual Framework and the relationship between them:
ASSETS less LIABILITIES equals EQUITY. Many Australian companies present their statements of
financial position in the order used by Wesfarmers.
MODULE 1
Notice also that it clearly analyses assets and liabilities between current items and non-current items.
Reproduced with permission from Wesfarmers Limited

23.2 STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE

INCOME
Definition
A statement of profit or loss and other comprehensive income is a record of income generated
and expenditure incurred over a given period. The statement shows whether the business has had
more income than expenditure (a profit) or more expenditure than income (loss).
The statement of profit or loss and other comprehensive income shows, as the name suggests:
(a) profit or loss for the period; and
(b) other comprehensive income.
Together profit or loss and other comprehensive income give total comprehensive income and this
statement may also be referred to as the statement of comprehensive income.
23.2.1 INCOME AND EXPENSES

Income within the statement of profit or loss and other comprehensive income is the income earned
within a period. The expenses are the costs of running the business for the same period.
23.2.2 OTHER COMPREHENSIVE INCOME

Certain items of income and expense do not form profit or loss for the year, and instead are
recognised as other comprehensive income. IAS 1 and other IFRSs specify the items which this applies
to, and requires that these are sub-classified according to whether they may be reclassified to profit or
loss at a future date.
23.2.3 FORM OF STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

The period chosen will depend on the purpose for which the statement is produced. The statement of
profit or loss and other comprehensive income which forms part of the published annual financial
statements of a limited liability company will usually be for the period of a year, commencing from
the date of the previous year's statements. On the other hand, management might want to keep a
closer eye on a company's profitability by making up quarterly or monthly statements from a
management accounting perspective.
The statement of profit or loss and other comprehensive income may be shown as a single statement
or in two statements. The example below shows the 'single statement approach', starting with
revenue and ending with total comprehensive income. The alternative approach includes:
1 A statement of profit or loss, showing line items from revenue to profit or loss for the year
2 A second statement, the statement of comprehensive income, showing profit for the year (i.e. the
total from 1 above) and items of other comprehensive income to give total comprehensive income
XYZ – STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME FOR THE YEAR
ENDED 31 DECEMBER 20X7
20X7 20X6
$'000 $'000
Revenue 415 000 375 000
Cost of sales (245 000) (230 000)
Gross profit 170 000 145 000
Other income 17 767 16 400
Distribution costs (9 000) (8 700)
Administrative expenses (20 000) (21 000)
Other expenses (2 100) (1 200)
Finance costs (8 000) (7 500)
Profit before tax 148 667 123 000
Income tax expense (30 417) (27 000)
Profit for the year from continuing operations 118 250 96 000
Loss for the year from discontinued operations – (30 500)
20X7 20X6
$'000 $'000
Profit for the year 118 250 65 500
Other comprehensive income:tems that may be reclassified to profit or

Remeasurement of financial assets (14 000) 20 000
Items that will not be reclassifofit or loss
MODULE 1
Gains on property revaluation 3 000 8 000
Other comprehensive income for the year (11 000) 28 000
Total comprehensive income for the year 107 250 93 500
Case study: Statement of profit or loss and other comprehensive income
The statement profit or loss of Wesfarmers Ltd Group for the year ended 30 June 2012 is shown
below. Wesfarmers presents two separate statements of financial performance: an income statement
and a statement of comprehensive income. Only the income statement is shown here.
Notice that Wesfarmers analyses items of income and expenses according to their nature. The
illustration above analyses expenses by their function. But the statement still clearly shows the two
elements: income and expenses.
Income statement
for the year ended 30 June 2012 – Wesfarmers Ltd Group and its controlled entities
Reproduced with permission from Wesfarmers Limited

23.3 OTHER FINANCIAL STATEMENTS

The statement of financial position and the statement of profit or loss and other comprehensive
income form the basis of the financial statements of most businesses.
In Module 3, we will explain how to prepare a statement of financial position and a statement of profit
or loss and other comprehensive income for a limited liability company in accordance with IAS 1
Presentation of Financial Statements. Under IFRS, limited liability companies are also required to
prepare a statement of changes in equity and a statement of cash flows, as well as notes to the
financial statements.
23.3.1 STATEMENT OF CHANGES IN EQUITY

The statement of changes in equity shows the movements in the various components of equity (share
capital, retained earnings and other reserves) for a period. The purpose of the statement is to show
the transactions between the company and its owners. These consist of:
 total comprehensive income for the year, made up of the profit or loss for the year (changes in
retained earnings), plus other comprehensive income (items such as revaluation gains which are
not included in profit or loss, but recognised in a separate reserve within equity);
 contributions from owners: issues of shares; and
 distributions to owners: dividends paid.
An example of a simple statement of changes in equity is shown below.
XYZ – STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 20X7
Other
Share Retained components
capital earnings of equity
Total
$'000 $'000 $'000 $'000
Balance at 1 Jan 20X7 600 000 210 300 21 200 831 500
Changes in equity for 20X7
Issue of share capital 50 000 – – 50 000
Dividends – (15 000) – (15 000)
Total comprehensive
income for the year – 118 250 (11 000) 107 250
Balance at 31 Dec 20X7 650 000 313 550 10 200 973 750
The preparation of a statement of changes in equity is covered in Module 3.
23.3.2 STATEMENT OF CASH FLOWS

The statement of cash flows shows all movements of cash and cash equivalents into and out of a
business during the accounting period. These cash flows are classified into operating, investing and
financing activities. The cash flows for each of these are totalled to give the net inflow or outflow of
cash for the period.
The statement of cash flows is covered in more detail in Module 3.
Question 19: Accounting information
The financial statements of a limited liability company will consist solely of the statement of financial
position and statement of profit or loss and other comprehensive income.
This statement is:
A true
B false
CHECKPOINT 4
 Transactions and other events are grouped together in broad classes and in this way their financial
effects are shown in the financial statements. These broad classes are the elements of financial
statements.
MODULE 1
 Financial position is shown by:
– assets
– liabilities
– equity
 Financial performance is shown by:
– income
– expenses
 Items which meet the definition of assets or liabilities may still not be recognised in financial
statements because they must also meet certain 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 reliably.
 The principal financial statements of a business are the statement of financial position and the
statement of profit or loss and other comprehensive income. Other statements include the
statement of changes in equity and the statement of cash flows.
1 Of what is the following statement a definition?

'A resource controlled by an entity as a result of past events and from which future economic
benefits are expected to flow to the entity.'
A asset
B equity
C liability
D expense
2 Which of the following is the correct definition of a liability?

A the residual interest in the assets of the entity after deducting all its liabilities
B a present obligation arising from past events from which future economic benefits are expected
to flow to the entity
C a resource controlled by an entity as a result of past events and from which future economic
benefits are expected to flow to the entity
D a present obligation arising from past events, the settlement of which is expected to result in an
outflow of resources embodying economic benefits
3 What are the criteria for recognition of items in the financial statements according to the IASB's
Conceptual Framework?
A probable that future economic benefit will flow to or from the entity
B probable that there will be outflow of future economic benefits and there is a past transaction
C probable that there will be an inflow or outflow of future economic benefits and there is a past
transaction
D probable that future economic benefit will flow to or from the entity and the item can be
measured with reliability
4 What items are recognised in the statement of profit or loss and other comprehensive income?
I equity
II assets
III income
IV liabilities
V expenses
A III only
B I and V only
C III and V only
D I, II, III, IV and V
5 Which of the following is an example of a current asset?

A retained earnings
B manufacturing licences
C property, plant and equipment
D motor vehicles held for sale as part of a trade
6 Which of the following items are non-current assets?

I land
II inventory
III bank loan
IV machinery
A I only
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B I and IV only
C I, III and IV only
D II, III and IV only
7 How is a bank overdraft classified in the statement of financial position?

A current asset
B current liability
C non-current asset
D non-current liability
8 How should the balance of accounts payable be reported in the financial statements?
A as an expense
B as a current asset
C as a current liability
D as a non-current asset
9 Which of the following is an example of a liability?

A loan
B inventory
C receivables
D plant and machinery
ANSWERS TO QUICK REVISION QUESTIONS 1
1 D The primary aim of accounting is to provide financial information for users.

2 C Lenders and shareholders in particular are identified as the primary users of financial
statements. Information produced with them in mind should also be useful for other user
groups, however these other groups are not considered to be the main audience of financial
accounts.
3 D Although shareholders need to know the future prospects, they also need to know that the
current position of the company is secure. Similarly, suppliers need to know the future
prospects to ensure that they will be paid.
4 A The International Accounting Standards Committee is the old name of the IASB; the IASB is
overseen by and accountable to the IFRS Foundation.
5 D The IFRS Foundation appoints the members of the IASB; the IFRS Interpretations Committee
issues Interpretations; and the IFRS Foundation oversees the work of the IFRS Interpretations
Committee.
6 B The IASB has no powers of enforcement.
7 C The IFRS Interpretations Committee interprets the application of IFRS and provides guidance
on topics not specifically covered by an IFRS.
8 D GAAP is all the rules and regulations a company must follow so can include national as well as
international standards.
9 B A, C and D are all perceived as disadvantages of the regulation of company financial
statements: more disclosure is required; the extra work involved in adhering to regulations is
costly and competitors have access to more information which they may use to their advantage.
Regulation does, however, result in higher quality, more comparable, relevant and faithfully
represented information.
10 D Although the issue of a discussion paper is not a mandatory step in due process, this would be
issued before the (mandatory) exposure draft, and in due course a final standard.
1 D A conceptual framework is sometimes referred to as a 'guiding light' which underpins

accounting standards.
2 A The framework provides the principles which underpin IFRS; in addition its principles are
applied where no standard exists. Therefore all transactions are effectively accounted for in line
with the framework, so resulting in standardised accounting practice.
3 B The Conceptual Framework for Financial Reporting is the name of the IASB's conceptual
framework.
4 B All are valid reasons that financial statements are produced, but the key reason is B.
5 D They are all uses of the financial statements.
6 A Existing and potential investors, lenders and other creditors (providers of capital).
7 D The underlying principles contained within the conceptual framework should be applied.
8 D I is a change of accounting estimate, III is specifically mentioned in IAS 8 as not constituting a
change of accounting policy.
9 A Material errors are treated in the same way as changes of accounting policy. They are corrected
retrospectively, so that the financial statements are presented as if the error had never
occurred.
1 B A principles based system discourages 'creative accounting' abuses. Principles are harder to
evade than rules. Many people believe that A and C are advantages of a rules based system. D
is often true of principles based standards, but many view this as a disadvantage.
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2 C All published financial statements must be fairly presented (or show a true and fair view).
Application of IFRS is presumed to result in a fair presentation (although additional disclosures
may be necessary).
3 B The other arguments are all in favour of accounting standards.
4 C The underlying assumption is going concern.
5 B These are the four qualitative characteristics contained within the Conceptual Framework which
enhance the usefulness of information that is relevant and faithfully represented.
6 C Materiality concerns whether an item in the financial statements can influence users' decisions.
A faithful representation must be free from error, but this does not mean perfectly accurate in
all respects.
7 A The accruals concept requires that the effects of transactions are recognised when they occur,
so meaning that credit sales and purchases, for example, are included in profit or loss for a
period.
8 A 16 IFRS have been published by the IASB.
9 B Investors will benefit as financial statements will be more comparable.
10 C The FASB is the US standard setter. It has worked with the IASB on a number of projects,
including new standards on business combinations, fair value measurement, financial
instruments and revenue recognition.
1 A This is the definition of an asset contained within the Conceptual Framework and various IFRS.
2 D This is the definition of a liability contained within the Conceptual Framework and various IFRS.
A is the definition of equity; C is the definition of an asset; B is a mixture of the definitions of a
liability and an asset.
3 D There are two elements to the recognition criteria: a probable flow of economic benefits and
reliable measurement. The 'past event' criteria forms part of the definitions of an asset and
liability and is not repeated within the recognition criteria.
4 C Assets, liability and equity are included in the statement of financial position.
5 D Motor vehicles are generally a non-current asset, however motor vehicles held for sale as part of
a trade are current assets in accordance with IAS 2 Inventories. Property, plant and equipment
and licences are non-current assets of a business; retained earnings are part of the equity in a
business.
6 B A bank loan is a liability of a business and inventory is a current asset.
7 B An overdraft is classed as current, even where there is a rolling facility, as it is repayable on
demand.
8 C Payable accounts are part of the normal operating cycle of a business, and as such are classified
as current liabilities, even where the credit period exceeds 12 months.
9 A B, C and D are all assets.
ANSWERS TO MODULE QUESTIONS
1 B Financial reporting is carried out by all businesses, no matter what their size or structure.
2 A Customers need to know that the business is making sufficient profits to be a secure source of
supply.
3 Other examples of areas where the judgment of different people may vary are as follows:
(a) Valuation of buildings in times of rising property prices
(b) Research and development: is it right to treat this only as an expense? In a sense it is an
investment to generate future revenue.
(c) Accounting for inflation
(d) Brands such as 'Coca Cola' or 'Hoover'. Are they assets in the same way that a fork lift truck is
an asset?
Working from the same data, different groups of people may produce very different financial
statements. If the exercise of judgment is completely unrestrained, there will be no comparability
between the accounts of different organisations. This will be all the more significant in cases where
deliberate manipulation occurs, in order to present accounts in the most favourable light.
4 Methods of 'creative accounting' include:
(a) 'Off balance sheet financing': an entity enters into a financing transaction which is structured
so that it can avoid having to recognise all its assets and liabilities in the statement of financial
position. For example, a company might sell an asset but enter into an agreement to
repurchase it after a set period of time. The substance of the transaction is that the company
has a loan (a liability) secured on the asset that has been 'sold' but legally, the company has
made a sale and so recognises cash and income. The company's financial performance and
particularly its financial position appear to be much stronger than they are. Transactions such as
these enable a company to 'hide' material borrowings from shareholders and other lenders.
(b) 'Window dressing': at the year-end an entity enters into transactions whose sole purpose is to
improve the appearance of the financial statements. For example, a company might make a
fictitious 'sale', which would be reversed by means of a credit note early in the new reporting
period. Revenue and profit would appear to be higher than they really were.
(c) 'Profit smoothing': in a profitable year an entity deliberately recognises a liability for future
expenditure to which it is not committed (for example, for a 'restructuring' or for future losses).
This 'provision' is then available to be released to profit or loss to increase profits in a poor year
(the provision is sometimes called the 'big bath').
(d) 'Aggressive earnings management': recognising sales revenue before it has been earned
(before the entity has actually delivered the goods or performed the services).
Most of the accounting scandals of the past 20 years have involved one or more of these. For
example, the management of Enron used a sophisticated form of off balance sheet financing to
mislead the users of its financial statements.
5 The types of economic decisions for which financial statements are likely to be used include the
following:
 decisions to buy, hold or sell equity investments;
 assessment of management stewardship and accountability;
 assessment of the entity's ability to pay employees;
 assessment of the security of amounts lent to the entity;
 determination of taxation policies;
 determination of distributable profits and dividends;
 inclusion in national income statistics; and/or
 regulations of the activities of entities.
6 The IASB Conceptual Framework recognises existing and potential investors, lenders and other
creditors as the primary users of financial statements.
(a) Investors are the providers of risk capital:
(i) Information is required to help make a decision about buying or selling shares, taking up a
rights issue and voting.
(ii) Investors must have information about the level of dividend, past, present and future and
MODULE 1
any changes in share price.
(iii) Investors will also need to know whether the management has been running the company
efficiently.
(iv) As well as the position indicated by the results (profit or loss) for the year, statement of
financial position and earnings per share (EPS), investors will want to know about the liquidity
position of the company, the company's future prospects, and how the company's shares
compare with those of its competitors.
(b) Lenders need information to help them decide whether to lend to a company. They will also
need to check that the value of any security remains adequate, that the interest repayments are
secure, that the cash is available for redemption at the appropriate time and that any financial
restrictions (such as maximum debt/equity ratios) have not been breached.
(c) Suppliers and other creditors need to know whether the company will be a good customer
and pay its debts.
Other potential users of financial information include:
(d) Employees need information about the security of employment and future prospects for jobs in
the company, and to help with collective pay bargaining.
(e) Customers need to know whether the company will be able to continue producing and
supplying goods.
(f) Government's interest in a company may be that of a creditor or customer, as well as being
specifically concerned with compliance with tax and company law, ability to pay tax and the
general contribution of the company to the economy.
(g) The public at large would wish to have information for all the reasons mentioned above, but it
could be suggested that it would be impossible to provide general purpose accounting
information which was specifically designed for the needs of the public.
7 (a) This is a change in presentation, so it does represent a change of accounting policy
(b) This is a change of accounting estimate, not a change of accounting policy
(c) This is a change of measurement basis, so it does represent a change of accounting policy
8 STATEMENT OF PROFIT OR LOSS
20X6 20X7
$'000 $'000
Sales 50 000 54 000
Income tax (7 785) (8 421)
9 CHANGE IN ACCOUNTING ESTIMATE

The change in accounting estimate affects the accounts for 20X7 and subsequent years. At
31/12/X7 the NBV of the asset is $60 000 (assuming that 20X7 depreciation has not yet been
charged). This should be spread over the revised remaining useful life, i.e. 3 years. Depreciation on
the asset for 20X7, 20X8 and 20X9 will be $20 000 per annum.
10 STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

20X6 20X7
$'000 $'000
Sales 47 400 67 200
Cost of goods sold (W1) (38 770) (51 600)
Income tax (W2) (2 589) (4 680)
RETAINED EARNINGS
20X6 20X7
Opening retained earnings $'000 $'000
As previously reported 13 000 21 981
Correction of prior period
error (4200 – 1260) – (2 940)
As restated 13 000 19 041
Closing retained earnings 19 041 29 961
Workings
1 Cost of goods sold 20X6 20X7
$'000 $'000
As stated in question 34 570 55 800
Inventory adjustment 4 200 (4 200)
38 770 51 600
2 Income tax 20X6 20X7
$'000 $'000
As stated in question 3 849 3 420
Inventory adjustment (4200 × 30%) (1 260) 1 260
2 589 4 680
11 (a) This standard is a hybrid of the two. It contains a principle (lease classification depends on
whether the lease transfers the risks and benefits of ownership to the lessee). It also contains a
rule for determining whether or not the risks and benefits are likely to have been transferred.
(b) There is a danger that management might ignore the basic principle and simply apply the rules,
particularly if this improved the entity's financial position. It is possible to structure a finance
lease agreement so that the present value of the minimum lease payments is 89 per cent of the
fair value of the leased asset. A lease that was in substance a finance lease could then be
treated as an operating lease for the purpose of the financial statements.
12 (a) If the business is to be closed down, the remaining three machines must be valued at the
amount they will realise in a forced sale, i.e. 3 × $60 = $180.
(b) If the business is viewed as a going concern, the inventory unsold at 31 December will be
carried forward into the following year, when the cost of the three machines will be matched
against the eventual sale proceeds in computing that year's profits. The three machines will
therefore be valued at cost, 3 × $100 = $300.
13 (a) This is an intangible asset. There is a past event, control and future economic benefit as a result
of cost savings.
(b) This cannot be classified as an asset. Baldwin Co has no control over the car repair shop and it
is difficult to argue that there are 'future economic benefits'.
(c) The warranty claims constitute a liability; the business has incurred an obligation. It would be
recognised when the warranty is issued rather than when a claim is made.
14 The accounting policies apply the definitions and the recognition criteria in the Conceptual
Framework for Financial Reporting (as well as the requirements of IAS 38 Intangible Assets).
Although expenditure on research activities may eventually result in future economic benefits (and
therefore there may be an asset) it cannot be capitalised because it does not meet the recognition
criteria: it is too early to say whether there will actually be any economic benefits or to be able to
make any kind of reliable estimate of the amount.
MODULE 1
In contrast, development expenditure is capitalised if it meets certain criteria. There is an asset: the
new product and the ideas behind it are controlled by the entity and there is expected to be an
inflow of economic benefits in the form of increased revenue or reduced costs. An intangible asset
is recognised if the product or process is technically and commercially feasible and there are
sufficient resources to complete development. If these criteria are met the inflow of economic
benefits is probable. The second criteria of reliable measurement is also met because the
amount to be capitalised is the cost of materials, labour and a proportion of overheads; these
amounts will be recorded in the company's accounting system.
If development expenditure does not meet the criteria it is not recognised as an asset, but as an
expense in the period in which it is incurred.
15 Because there is only a 40 per cent chance of the claim succeeding it is (a) not clear whether the
company has a liability and (b) even if there is a liability it fails to meet the recognition criteria (it is
only possible, not probable, that the entity will be found liable and that there will be an outflow of
economic benefits in the form of damages paid).
This is a contingent liability (as defined by IAS 37 Provisions, Contingent Liabilities and Contingent
Assets): a possible obligation whose existence will be confirmed only by the occurrence or non-
occurrence of an uncertain future event not wholly within the control of the entity or a present
obligation that is not recognised because it is not probable that an outflow of economic benefits
will be required in settlement.
The company should not recognise a liability (a provision). Instead, it should disclose the possible
liability in the notes to the financial statements.
16 The preference shares are a non-current liability and should not be presented as part of equity in
the statement of financial position. They have the characteristics of a loan, rather than an owners'
interest. A liability exists because the company has an obligation to pay interest over the life of the
'shares' and eventually to repay the principal amount.
17 In order for an entity to recognise revenue, there must be an increase in its net assets. Customers
pay for airline tickets before they actually receive the service that they have paid for. The terms of
airline tickets vary. In some cases the passenger can only fly on the date and to the destination
originally booked, but in other cases tickets may be exchangeable, transferable or refundable or
they may be valid for travel during a particular period, rather than on a specific flight.
The airline group does not recognise revenue until passengers actually travel, i.e. when it actually
delivers the service that has been paid for. Depending on the terms of the ticket, until that time the
company probably has a liability in the form of an obligation to make a refund to the customer or
to offer another flight. When the customer actually travels, the liability is discharged. The
recognition conditions are met: there is a decrease in a liability, and a certain inflow of economic
benefit which can be reliably measured.
Unused tickets can be recognised as revenue in certain conditions. For example, where a customer
books a ticket that only permits travel on a specific flight and then fails to travel, the company still
receives the cash paid for the ticket (an inflow of economic benefit that meets both recognition
conditions) but has no obligation to provide another flight.
18 In the current period

The company has sunk a mine in the current period but has not yet commenced the extraction of
minerals.
As a result of sinking the mine, at the year-end, the company has a legal obligation to restore the
site at the end of the mine's operating life. It therefore has a liability which meets both the
recognition criteria:
(a) the outflow of economic benefits is probable, even though it may not occur for many years; and
(b) the amount can be reliably estimated (on the basis of the amount it would cost to restore the
site at the year-end, adjusted as necessary for expected future changes in technology etc).
The company should therefore recognise a liability in respect of 40 per cent of the total cost of
restoring the site at the end of the mine's operating life. The remaining 60 per cent of the eventual
cost of restoration is the result of extracting minerals. As this activity has not yet commenced, there
is no related liability.
The restoration costs recognised as a liability also meet the definition of an asset (the expenditure
will generate future economic benefits in the form of sales revenue) and also meet the recognition
criteria: an inflow of economic benefit is probable and the cost of restoration can be reliably
estimated. Therefore these costs form part of the cost of the mine within non-current assets.
In subsequent periods
The remaining 60 per cent of the eventual total cost of restoration relates to damage caused
progressively as minerals are extracted. Therefore as this damage occurs over the mine's operating
life, the liability for restoration costs is increased.
19 B A complete set of financial statements for a limited company (reporting entity) normally
includes:
 a statement of the entity's financial position;
 a statement or statements showing the entity's financial performance;
 a statement showing changes in the entity's financial position (usually a statement of cash
flows);
 a statement showing changes in equity; and
 notes to the financial statements and other supplementary information.
97
MODULE 2
THE ACCOUNTING
THEORY
Learning objectives Reference
Compare historical cost accounting with other methods of valuation and explain the LO2.1
differences
Explain agency and contracting theories and how they relate to accounting policy LO2.2
choice (positive accounting theory)
Apply the recognition criteria for the elements of the financial statements according to LO2.3
the conceptual framework (normative theory)
Topic list
1 Historical cost accounting

2 Measurement of the elements of financial statements
3 Positive and normative accounting theory
4 Alternatives to historical cost
5 Concepts of capital and capital maintenance
6 Current purchasing power (CPP)
7 Current cost accounting (CCA)
8 Agency theory
9 Information provided in annual reports
10 Information available to shareholders
11 Content of company reports
98 | THE ACCOUNTING THEORY
SUBJECT OUTLINE
In this module we look at the advantages and disadvantages of using historic cost to measure assets
and liabilities. Following on from that, we look at other measurement bases that can be used in
financial statements including fair value, deprival value, replacement cost and net realisable value.
We then consider the alternatives to historical cost accounting. These are different ways of measuring
profit that attempt to include the effect of price changes: current purchasing power accounting and
current cost accounting.
We also examine agency theory and the elements of the relationship between shareholders and
directors. We take this further by looking at the information disclosed in the annual report and
financial statements that enables shareholders to assess the performance of the company. Some of
this information is mandatory (it must be provided) and some is provided voluntarily.
The module content is summarised in the diagrams below.
The accounting theory
Alternative methods
of valuation
Historical cost accounting Measurement of the elements of

• Assets are recorded at the amounts financial statements
paid/received at acquisition Measurement options other than
historical cost include:
Problems:
MODULE 2
• Inflation • replacement cost/current value
• Increases in asset values are not • net realisable value
reflected in financial statements • deprival value
• fair value
Advantages:
• Objective method
• Costs can easily be verified
Theories of
accounting
Positive and normative Alternatives to historical cost: Concepts of capital and

•
theories • Current value accounting capital maintenance
• Positive: accounting theory • Increased use of fair values in • Financial capital maintenance:
explains actual accounting financial statements profits is the difference between
practice income and expenses as in
• Normative: accounting theory historical cost accounting
explains what should occur, • Physical (operating) capital
not what actually does maintenance:
profit is the increase in physical
productive capital
Current purchasing power (CPP) Current cost accounting (CCA)

• Profit is difference between • Capital maintenance approach
capital at beginning and end of based on maintaining operating
period capability
• Capital must be maintained so • Assets consumed, owned or sold
must take account of effect of should be shown at the value to the
inflation business, ie deprival value
Reporting and disclosure
Agency theory Information provided in annual

• Principal tasks the agent with report
undertaking a task on their behalf • Mandatory information includes financial
• Shareholders task directors and statements
management to run company on their • Voluntary information includes:
behalf – sustainability reports
• Problems occur if agent doesn’t act in – management commentary
best interest of principal – corporate governance
• Agency costs incurred by principal – risk information
monitoring activities of agent • Aim ofi nformation is to provide
shareholders with understanding of the
company’s activities in the period
BEFORE YOU BEGIN
If you have studied these topics before, you may wonder whether you need to study this module in
full. If this is the case, please attempt the questions below, which cover some of the key subjects in the
area.
If you answer all these questions successfully, you probably have a reasonably detailed knowledge of
the subject matter, but you should still skim through the module to ensure that you are familiar with
everything covered.
There are references in brackets indicating where in the module you can find the information, and you
will also find a commentary at the back of the Study Guide.
1 Explain the historical cost basis of measurement. (Section 1.1)
2 What are the problems of the historical cost basis of measurement? (Sections 1.2 and 2.6)
3 Which of the following are examples of deprival value?
I net realisable value
MODULE 2
II replacement cost
III historical cost
IV economic value
V fair value
A I and IV only
B II and IV only
C I, II and IV only
D II, III and V only (Section 2.3)
4 What is the definition of fair value? (Section 2.4)
5 What is a normative accounting theory? (Section 3.3)
6 What is physical capital maintenance? (Section 5.1)
7 What is current purchasing power accounting? (Section 6)
8 What is current cost accounting? (Section 7)
9 What is an agency relationship? (Section 8.1)
10 What principal–agent relationships may exist in the context of a company? (Sections 8.3 and 8.7)
11 What is the purpose of corporate governance disclosures? (Section 9.2.1)
12 What are the advantages of disclosing non-mandatory information such as
social reports? (Section 9.2.3)
13 What information does a corporate governance report contain? (Section 11.4)
14 What information does a corporate social responsibility report contain? (Section 11.5)
1 HISTORICAL COST ACCOUNTING
Section overview
 A basic principle of accounting is that transactions are normally stated at their historical
amount.
 Historical cost is the most commonly adopted measurement basis, but this is often
combined with other bases, such as net realisable value or fair value.
 Although historical cost is objective, there are some problems associated with using it.
1.1 SUBJECT OUTLINE

Accounting concepts are part of the theoretical framework on which accounting practice is based. It is
worth looking at one further general point: the problem of attributing monetary values to the items
which appear in financial statements.
A basic principle of accounting (some writers include it in the list of fundamental accounting concepts)
is that transactions are normally stated in accounts at their historical cost.
Measurement is defined below.
Definition
Measurement. The process of determining the monetary amounts at which the elements of the
financial statements are to be recognised and carried in the statement of financial position and
statement of profit or loss and other comprehensive income. (Conceptual Framework)
This involves the selection of a particular basis of measurement. A number of these are used to
different degrees and in varying combinations in financial statements. The Conceptual Framework
provides the following definitions:
Definitions
Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value
LO of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at
2.1 the amount of proceeds received in exchange for the obligation, or in some circumstances (for
example, income taxes), 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 their
settlement values; that is, the undiscounted amounts of cash or cash equivalents expected to be paid
to satisfy the liabilities in the normal course of business.
Present value. A current estimate of the present discounted value of the future net cash flows in the
normal course of business. (Conceptual Framework)
Historical cost is the most commonly adopted measurement basis, but this is usually combined with
other bases, e.g. inventory is carried at the lower of cost and net realisable value, marketable
securities and non-current assets may be carried at market value (or fair value) and pension liabilities
are carried at their present value.
During the 1970s and 1980s some entities used current cost as a way of dealing with the effects of
high rates of inflation. However, at the present time current cost is used very rarely.
1.2 HISTORICAL COST

Definition
The historical cost convention has a number of implications:

LO  Transactions are recorded at original cost. This means, for example, that the cost of goods sold is
2.1
not suddenly increased at the end of the year.
 Assets are stated at their historical cost. In other words, the value of an asset in a statement of
financial position is based on the price that was paid for it.
MODULE 2
An important advantage of this convention is that there is usually objective, documentary evidence to
prove the purchase price of an asset, or amounts paid as expenses.
In general, accountants prefer to deal with objective costs, rather than with estimated values. This is
because valuations tend to be subjective and to vary according to the purpose of the valuation. There
are some problems with the principle of historical cost which include the following:
(a) the wearing out of assets over time;
(b) the increase in market value of property; and
(c) inflation.
You may be able to think of other problems.
Worked Example: Problems with historical cost
Suppose that a partnership buys a machine to use in its business. The machine has an expected useful
life of four years. At the end of two years the partnership is preparing a statement of financial position
and has to decide what monetary amount to attribute to the asset. Numerous possibilities might be
considered:
 the original cost (historical cost) of the machine;
 half of the historical cost, on the basis that half of its useful life has expired;
 the amount the machine might fetch on the second-hand market;
 the amount it would cost to replace the machine with an identical machine;
 the amount it would cost to replace the machine with a more modern machine incorporating the
technological advances of the previous two years; and/or
 the machine's economic value, i.e. the amount of the profits it is expected to generate for the
partnership during its remaining life.
All of these valuations have something to recommend them, but the great advantage of the first two is
that they are based on a figure (the machine's historical cost) which is objectively verifiable.
2 MEASUREMENT OF THE ELEMENTS OF

FINANCIAL STATEMENTS
Section overview
 Besides historical cost, there are a variety of other possible methods of measurement:
– Fair value
– Deprival value
– Replacement cost
– Net realisable value
 The main advantage of historical cost accounting is that the cost of an item is known and
can be proved. There are also a number of disadvantages and these usually arise in times
of rising prices (inflation). Other disadvantages have arisen as business practice and
transactions have become more complex.
2.1 REPLACEMENT COST

Definition
Replacement cost means the amount needed to replace an item with an identical item. This is the
LO same as current cost.
2.1
Worked Example: Replacement cost
XY Co purchased a machine five years ago for $15 000. It is now worn out and needs replacing.
An identical machine can be purchased for $20 000.
Historical cost is $15 000
Replacement cost is $20 000
2.2 NET REALISABLE VALUE

Definition
Net realisable value is the expected price less any costs still to be incurred in getting the item ready
LO for sale and then selling it.
2.1
Worked Example: Net realisable value
XY Co's machine from the example above can be restored to working order at a cost of $5000. It can
then be sold for $10 000. What is its net realisable value?
Net realisable value = $10 000 – $5000
= $5000
2.3 DEPRIVAL VALUE

Definition
Deprival value is the loss which a business entity would suffer if it were deprived of the use of the
asset.

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FOUNDATION EXAM

Seventh edition 2017

This book is printed on FSC accredited stock

International Education Standards

YOU AND YOUR STUDY PLAN

ADDITIONAL LEARNING SUPPORT

STANDARDS AND LEGISLATION

Revision questions 387

Answers to revision questions 411

Before you begin questions: Answers and commentary 425

Glossary of terms 443

Learning Show the referenced CPA Australia learning objectives.

Introduction Presents a general idea of what is covered in this module.

Worked example This is an illustration of a particular technique or concept with a solution or

Checkpoint Review the key areas covered in the module.

PREPARING FOR YOUR FOUNDATION EXAM

TIPS FOR EXAMS

ANSWERING MULTIPLE CHOICE QUESTIONS

COMPUTER-BASED EXAM NAVIGATION

MODULE 1 – THE FINANCIAL REPORTING ENVIRONMENT

MODULE 2 – THE ACCOUNTING THEORY

MODULE 3 – FINANCIAL STATEMENTS

MODULE 4 – APPLICATION OF SPECIFIC ACCOUNTING

MODULE 5 – BUSINESS COMBINATIONS

MODULE 6 – ANALYSIS OF FINANCIAL STATEMENTS

FINANCIAL ACCOUNTING AND REPORTING

1 The Financial Reporting Environment 28%

1 The purpose of accounting

The ﬁnancial reporting environment

Financial reporting involves

IASB issues Standards

The Conceptual Framework and

IAS 8 Accounting Policies, Changes

Accounting standards and concepts

Role of accounting standards Accounting concepts International harmonisation

Elements of ﬁnancial Recognition criteria The main elements of

BEFORE YOU BEGIN

18 Explain the concept of 'substance over form' and provide an example of

1 THE PURPOSE OF ACCOUNTING

1.1 WHAT IS ACCOUNTING?

1.2 FINANCIAL ACCOUNTING

1.3 MANAGEMENT ACCOUNTING

Management accounting, sometimes known as cost accounting, is a management information

1.4 WHAT IS A BUSINESS?

Businesses of whatever size or nature exist to make a profit.

1.5 TYPES OF BUSINESS ENTITY

1.5.1 NON-COMMERCIAL UNDERTAKINGS

2 NATURE, PRINCIPLES AND SCOPE OF FINANCIAL

2.1 WHAT IS FINANCIAL REPORTING?

2.2 GENERAL PURPOSE FINANCIAL REPORTING

2.3 LIMITATIONS OF FINANCIAL REPORTING

Question 1: Financial reporting

3 THE REPORTING ENTITY

4 USERS' AND STAKEHOLDERS' NEEDS

4.1 THE NEED FOR FINANCIAL STATEMENTS

4.1.1 MAKING ECONOMIC DECISIONS

4.2 USERS OF FINANCIAL STATEMENTS AND ACCOUNTING

4.3 NEEDS OF DIFFERENT USERS

Question 2: Information needs