In March 2018, the International Accounting Standards Board (the Board) finished its revision of The Framework for Financial Reporting (the Framework).
The primary purpose of financial information is to be useful to existing and potential investors, lenders and other creditors (users) when making decisions about the financing of the entity and exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources. The Framework sets out the information needed to assess management’s stewardship, and separates this from the information that users need to assess the prospects of the entity’s future net cash flows.
Chapter 1 – The objective of general-purpose financial reporting
The purpose of the Framework is to:
- assist the IASB to develop and revise its standards
- assist entities to develop consistent accounting policies when no standard applies to a particular transaction or other event, or when a standard allows a choice of accounting policy, and
- assist all stakeholders to understand and interpret the standards
IFRSs take precedence over the Framework. However, should new IFRSs depart from the Framework, the IASB will explain the reasons in the Basis for Conclusions on that standard.
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 Framework and within financial reporting, so this statement largely reinforces what already exists.
Users base their expectations of returns on their assessment of:
- the amount, timing and uncertainty of future net cash inflows to the entity, and
- management’s stewardship of the entity’s resources.
Chapter 2 – Qualitative characteristics of useful financial information
The Framework sets out the qualitative characteristics of useful financial information. However, these characteristics are subject to cost constraints, and it is therefore important to determine whether the benefits to users of the information justify the cost incurred by the entity providing it. The Framework clarifies what makes financial information useful, that is, information must be relevant and must faithfully represent the substance of financial information.
Relevance and faithful representation remain as the two fundamental qualitative characteristics. The four enhancing qualitative characteristics continue to be timeliness, understandability, verifiability and comparability.
Whilst the qualitative characteristics remain unchanged, the Board decided to reinstate explicit references to prudence and substance over form.
Prudence is introduced in support of the principle of neutrality for the purposes of faithful representation. Prudence is understood here as the exercise of caution when making judgements under conditions of uncertainty. Users find this concept important as they feel that it should help counteract the natural optimistic bias of management. By acknowledging neutrality and prudence, the Framework includes all conceptual underpinnings for the development of IFRSs.
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.
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 Framework should not identify asymmetric prudence as a necessary characteristic of useful financial reporting.
The 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.
Many users would prefer the concept of measurement reliability, but the Framework provides clarification concerning measurement uncertainties which are defined in terms of faithful representation. Faithful representation of information does not mean that that information must be accurate in all respects. As the use of estimates are an essential part of the preparation of financial information and this does not necessarily weaken the usefulness of the information. The Framework strikes a balance between relevance and faithful representation in order to provide useful information to the users of financial statements. Information with a very high degree of uncertainty should be replaced by information whose estimation involves less uncertainty as long as explanations are provided. The IASB states that a faithful representation provides information about the substance of an economic phenomenon instead of merely providing information about its legal form.
Chapter 3 – Financial statements and the reporting entity
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.
It is useful to users to understand that the general purpose financial statements are prepared on the assumption that the reporting entity is a going concern. If this assumption is not appropriate, they are prepared in accordance with a basis other than IFRSs. The Framework explains that this assumption means that the entity has neither the intention nor the need to enter liquidation or cease trading in the foreseeable future. The Framework also states that the financial statements are prepared from the perspective of the reporting entity as a whole, not from the perspective of some or all of the entity’s users. This is a useful clarification for users, because in practice the perspective taken in drafting the various standards is not always clear.
Chapter 4 – The elements of financial statements
The Board has changed the definitions of assets and liabilities. 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.|
|Economic resource||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.|
|Obligation||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
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 Framework addresses this specifically as 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 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 Framework but the 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
The selection of a measurement basis must take into account the key characteristics of useful financial information (relevance and faithful representation) and more particularly the characteristics of the element, the contribution to cash flows due to economic activities, and measurement uncertainty and the cost constraint.
A balance is needed between giving entities the flexibility to provide relevant information that faithfully represents the entity’s assets, liabilities, equity, income and expenses; and requiring information that is comparable, both from period to period and across entities.
Effective communication in financial statements is also supported by considering that entity-specific information is more useful than standardised descriptions and duplication of information in different parts of the financial statements is usually unnecessary and can make financial statements less understandable.
The first of the measurement bases discussed is historical cost. The accounting treatment of this is unchanged, but the 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 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.
Relevance is a key issue. The Framework says 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 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 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 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.
The Framework 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.