A building renovation can be tricky and it can be overwhelming: at the beginning, you definitely know that some parts of the building need to be upgraded, but you can often find more and more that needs to be fixed after the renovation begins. Often, the project can take longer than you ever anticipated, and you change much more of the building than you originally planned.
In March 2018, the International Accounting Standards Board (the Board) finished its renovation of The Conceptual Framework for Financial Reporting (the Conceptual Framework). Much like a renovation and its implications for the existing building, the Board needed to consider that too many changes to the Conceptual Framework may have knock-on effects to existing International Financial Reporting Standards (IFRS®). Despite that, the Board has now published a new version of the Conceptual Framework, and this article considers some of the more significant changes to the Conceptual Framework that the Board has made.
Chapter 1 – The objective of general purpose financial reporting
A gentle introduction
As with any major renovation, all issues, both significant and minor, need to be considered. When considering the objective of general purpose financial reporting, the Board reintroduced the concept of ‘stewardship’. This is a relatively minor change and, as many of the respondents to the Discussion Paper highlighted, stewardship is not a new concept. The importance of stewardship by management is inherent within the existing Conceptual Framework and within financial reporting, so this statement largely reinforces what already exists.
Chapter 2 – Qualitative characteristics of useful financial information
Originally, the Board had not planned to make any changes to this chapter, however following many comments made in responses to the Discussion Paper, there have been some.
Leaving the foundations in place
Primarily, the qualitative characteristics remain unchanged. Relevance and faithful representation remain as the two fundamental qualitative characteristics. The four enhancing qualitative characteristics continue to be timeliness, understandability, verifiability and comparability.
Restoring the original features
Whilst the qualitative characteristics remain unchanged, the Board decided to reinstate explicit references to prudence and substance over form.
Although these two concepts were removed from the 2010 Conceptual Framework, the Board concluded that substance over form was not a separate component of faithful representation. The Board also decided that, if financial statements represented a legal form that differed from the economic substance, then they could not result in a faithful representation.
Whilst that statement is true, the Board felt that the importance of the concept needed to be reinforced and so a statement has now been included in Chapter 2 that states that faithful representation provides information about the substance of an economic phenomenon rather than its legal form.
In the 2010 Conceptual Framework, faithful representation was defined as information that was complete, neutral and free from error. Prudence was not included in the 2010 version of the Conceptual Framework because it was considered to be inconsistent with neutrality. However, the removal of the term led to confusion and many respondents to the Board’s Discussion Paper urged for prudence to be reinstated.
Therefore, an explicit reference to prudence has now been included in Chapter 2, stating that ‘prudence is the exercise of caution when making judgements under conditions of uncertainty’.
Is that level?
As is often the case with a building project, making one minor change may lead to others, and everyone wants a building that is level. The problem with adjusting the building blocks here, even slightly, was that by adding in the reference to prudence, the Board encountered the further issue of asymmetry.
Many standards, such as International Accounting Standard (IAS®) 37, Provisions, Contingent Liabilities and Contingent Assets, apply a system of asymmetric prudence. In IAS 37, a probable outflow of economic benefits would be recognised as a provision, whereas a probable inflow would only be shown as a contingent asset and merely disclosed in the financial statements. Therefore, two sides in the same court case could have differing accounting treatments despite the likelihood of the pay-out being identical for either party. Many respondents highlighted this asymmetric prudence as necessary under some accounting standards and felt that a discussion of the term was required. Whilst this is true, the Board believes that the Conceptual Framework should not identify asymmetric prudence as a necessary characteristic of useful financial reporting.
The 2018 Conceptual Framework states that the concept of prudence does not imply a need for asymmetry, such as the need for more persuasive evidence to support the recognition of assets than liabilities. It has included a statement that, in financial reporting standards, such asymmetry may sometimes arise as a consequence of requiring the most useful information.
Chapter 3 – Financial statements and the reporting entity
Building the extension
Since the inception of the Conceptual Framework, the chapter on the reporting entity has been classified as ‘to be added’. Finally, this part of the extension has been built, even though it might be described as an extension built out of practicality, rather than excitement.
This addition relates to the description and boundary of a reporting entity. The Board has proposed the description of a reporting entity as: an entity that chooses or is required to prepare general purpose financial statements.
This is a minor terminology change and not one that many examiners could have much enthusiasm for. Therefore, it is unlikely to feature in many professional accounting exams!
Chapter 4 – The elements of financial statements
Not to everyone’s taste
As part of this project, the Board has changed the definitions of assets and liabilities. To casual observers, it may seem like some of these changes are the decorative equivalent of ‘repainting cream walls as magnolia’, but to some accountants it can feel like a seismic change.
The changes to the definitions of assets and liabilities can be seen below.
Asset (of an entity)
A resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
A present economic resource controlled by the entity as a result of past events.
A right that has the potential to produce economic benefits
Liability (of an entity)
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.
A present obligation of the entity to transfer an economic resource as a result of past events.
An entity’s obligation to transfer and economic resource must have the potential to require the entity to transfer an economic resource to another party.
A duty of responsibility that an entity has no practical ability to avoid.
The Board has therefore changed the definitions of assets and liabilities. Whilst the concept of ‘control’ remains for assets and ‘present obligation’ for liabilities, the key change is that the term ‘expected’ has been replaced. For assets, ‘expected economic benefits’ has been replaced with ‘the potential to produce economic benefits’. For liabilities, the ‘expected outflow of economic benefits’ has been replaced with the ‘potential to require the entity to transfer economic resources’.
The reason for this change is that some people interpret the term ‘expected’ to mean that an item can only be an asset or liability if some minimum threshold were exceeded. As no such interpretation has been applied by the Board in setting recent IFRS Standards, this definition has been altered in an attempt to bring clarity.
The Board has acknowledged that some IFRS Standards do include a probability criterion for recognising assets and liabilities. For example, IAS 37 Provisions, Contingent Liabilities and Contingent Assets states that a provision can only be recorded if there is a probable outflow of economic benefits, while IAS 38 Intangible Assets highlights that for development costs to be recognised there must be a probability that economic benefits will arise from the development.
The proposed change to the definition of assets and liabilities will leave these unaffected. The Board has explained that these standards don’t rely on an argument that items fail to meet the definition of an asset or liability. Instead, these standards include probable inflows or outflows as a criterion for recognition. The Board believes that this uncertainty is best dealt with in the recognition or measurement of items, rather than in the definition of assets or liabilities.
Chapter 5 – Recognition and derecognition
In terms of recognition, the 2010 Conceptual Framework specified three recognition criteria which applied to all assets and liabilities:
- the item needed to meet the definition of an asset or liability
- it needed to be probable that any future economic benefit associated with the asset or liability would flow to or from the entity
- the asset or liability needed to have a cost or value that could be measured reliably.
The Board has confirmed a new approach to recognition, which requires decisions to be made by reference to the qualitative characteristics of financial information. The Board has confirmed that an entity should recognise an asset or a liability (and any related income, expense or changes in equity) if such recognition provides users of financial statements with:
- relevant information about the asset or the liability and about any income, expense or changes in equity
- a faithful representation of the asset or liability and of any income, expenses or changes in equity, and
- information that results in benefits exceeding the cost of providing that information
A key change to this is the removal of a ‘probability criterion’. This has been removed as different financial reporting standards apply different criterion; for example, some apply probable, some virtually certain and some reasonably possible. This also means that it will not specifically prohibit the recognition of assets or liabilities with a low probability of an inflow or outflow of economic resources.
This is potentially controversial, and the 2018 Conceptual Framework addresses this specifically in chapter 5; paragraph 15 states that ‘an asset or liability can exist even if the probability of an inflow or outflow of economic benefits is low’.
The key point here relates to relevance. If the probability of the event is low, this may not be the most relevant information. The most relevant information may be about the potential magnitude of the item, the possible timing and the factors affecting the probability.
Even stating all of this, the Conceptual Framework acknowledges that the most likely location for items such as this is to be included within the notes to the financial statements.
Finally, a major change in chapter 5 relates to derecognition. This is an area not previously addressed by the Conceptual Framework but the 2018 Conceptual Framework states that derecognition should aim to represent faithfully both:
(a) the assets and liabilities retained after the transaction or other event that led to the derecognition (including any asset or liability acquired, incurred or created as part of the transaction or other event); and
(b) the change in the entity’s assets and liabilities as a result of that transaction or other event.
Chapter 6 – Measurement
A new en-suite?
The 2010 version of the Conceptual Framework did not contain a separate section on measurement bases as it was previously felt that this was unnecessary. However, when presented with the opportunity of re-drafting the Conceptual Framework, some additions which are helpful and practical may be considered, even if we have previously managed without them.
In the 2010 Framework, there were a brief few paragraphs that outlined possible measurement bases, but this was limited in detail. In the 2018 version, there is an entire section devoted to the measurement of elements in the financial statements.
The first of the measurement bases discussed is historical cost. The accounting treatment of this is unchanged, but the Conceptual Framework now explains that the carrying amount of non-financial items held at historical cost should be adjusted over time to reflect the usage (in the form of depreciation or amortisation). Alternatively, the carrying amount can be adjusted to reflect that the historical cost is no longer recoverable (impairment). Financial items held at historical cost should reflect subsequent changes such as interest and payments, following the principle often referred to as amortised cost.
The 2018 Conceptual Framework also describes three measurements of current value: fair value, value in use (or fulfilment value for liabilities) and current cost.
Fair value continues to be defined as the price in an orderly transaction between market participants. Value in use (or fulfilment value) is defined as an entity-specific value, and remains as the present value of the cash flows that an entity expects to derive from the continuing use of an asset and its ultimate disposal.
Current cost is different from fair value and value in use, as current cost is an entry value. This looks at the value in which the entity would acquire the asset (or incur the liability) at current market prices, whereas fair value and value in use are exit values, focusing on the values which will be gained from the item.
In addition to outlining these measurement bases, the Conceptual Framework discusses these in the light of the qualitative characteristics of financial information. However, it stops short of recommending the bases under which items should be carried, but gives some guidance in the form of examples to show where certain bases may be more relevant.
Relevance is a key issue here. The 2018 Conceptual Framework discusses that historical cost may not provide relevant information about assets held for a long period of time, and are certainly unlikely to provide relevant information about derivatives. In both cases, it is likely that some variation of current value will be used to provide more predictive information to users.
Conversely, the Conceptual Framework suggests that fair value may not be relevant if items are held solely for use or to collect contractual cash flows. Alongside this, the Conceptual Framework specifically mentions items used in a combination to generate cash flows by producing goods or services to customers. As these items are unlikely to be able to be sold separately without penalising the activities, a cost-based measure is likely to provide more relevant information, as the cost is compared to the margin made on sales.
Chapter 7 – Presentation and disclosure
This is a new section, containing the principles relating to how items should be presented and disclosed.
The first of these principles is that income and expenses should be included in the statement of profit or loss unless relevance or faithful representation would be enhanced by including a change in the current value of an asset or a liability in OCI.
The second of these relates to the recycling of items in OCI into profit or loss. IAS 1 Presentation of Financial Statements suggests that these should be disclosed as items to be reclassified into profit or loss, or not reclassified.
The wisdom of crowds?
The recycling of OCI is contentious and some commenters argue that all OCI items should be recycled. Others argue that OCI items should never be recycled, whilst some argue that only some items should be recycled. Sometimes the best way forward on a project isn’t necessarily to seek the wisdom of crowds.
The foreman’s call
Luckily, the Board has managed to find a middle ground on recycling. The 2018 Conceptual Framework now contains a statement that income and expenses included in OCI are recycled when doing so would enhance the relevance or faithful representation of the information. OCI may not be recycled if there is no clear basis for identifying the period in which recycling should occur.
To the majority of preparers, these changes to the Conceptual Framework will have little or no impact on the financial statements and they are seen as minor terminology changes which simply confirm what is already in existence. However, for ACCA candidates, some of these changes such as recognition and measurement are key and can be examined in both the Financial Reporting and Strategic Business Reporting exams.