Week 2 The Conceptual Framework Financial Accounting BFA

Week 2: The Conceptual Framework Financial Accounting BFA 201

Learning Objectives • Understand the development of accounting regulation • Understand the structure & role of the conceptual framework • Explain the need for an accounting standard on fair value measurement • Understand the key characteristics of the term ‘fair value’ 2

Readings and references • Deegan Ch. 2 • AASB Framework, SAC 1 & 2 • Scan AASB 1053; AASB 2010 -2 • Scan AASB 1031; AASB 13 3

What is a Conceptual Framework? • Set of guiding principles 1. 2. 3. Objectives of GPFS Qualitative Characteristics Elements • Underpins accounting practice 4

History • US 1929 stock market crash ? accounting – 1959 Accounting Principles Board (APB) (profession) APB Statement 4 ‘Basic Concepts & Accounting Principles…’ – 1973 FASB (independent) CF 6 Statements • CFs also developed in Aust, UK, Canada, NZ & IASC … limited progress! In Aust: – 1970 & 1972 AARF(profession) – adaptation of APB Statement 4 AASB (independent) - 2005 IASB – adopted IFRS; withdrawal of SAC 3 & 4, but kept SAC 1 & 2 5

Australian Conceptual Framework Consists of 3 documents: 1. SAC 1 ‘Definition of Reporting Entity’ 2. SAC 2 ‘Objective of General Purpose Financial Reporting’ 3. The ‘Framework for the Preparation and Presentation of Financial Statements’ 6

IASB Framework 1. Definition of Financial Reporting 2. Def. Reporting Entity 3. Def. Users & Needs 4. Objectives of Financial statements 5. Underlying Assumptions 6. Qualitative characteristics 7. Elements 8. Recognition Criteria 9. Measurement 7

SAC 1 1. GPFR = Common needs 2. External users 3. Users lack power to demand information • • Reporting Entity Concept In accounting = Dependent User 8

SAC 2: Objective “GPFRs shall provide information useful to users for making and evaluating decisions about the allocation of scarce resources” (para. 43) • Users • Should financial reports be understandable to all users? 9

Differential reporting Key Changes • 2009 IFRS for SMEs • • IFRS – costly & user needs not met 2010 ED 192 proposed: – Remove ‘Reporting Entity’ (dependent users) – Add ‘Public Accountability’ concept (only external resource providers) – No SPFR 10

Reduced disclosure regime • AASB 1053 Application of Tiers to Australian Accounting Standards (from 1 July 2013; early adoption from 1 July 2010) – Reduced disclosures (See AASB 2010 -2) – Same Recognition & Measurement requirements as full IFRS 11

AASB Framework • • • Purpose Scope Users Objectives Assumptions = Accrual & Going Concern Characteristics – 2 types 1. Qualitative Characteristics 2. Constraints 12

Qualitative characteristics 1. Understandability 2. Relevance 3. Reliability 4. Comparability 13

Selection 1. Relevance – Assists decision making – Nature of Information & Materiality 2. Reliability – Free from bias & material error – Faithful representation • Substance over form • Neutrality • Prudence • Completeness 14

Materiality 1. If omission or misstatement is influential (Framework, par 30) 2. Test for materiality (AASB 1031 par 13): Material = > 10% Not material =< 5% Between 5% & 10% ? ? ? Professional judgment 15

Presentation 1. Understandability – – 2. Assumes reasonable knowledge Complex information Comparability Ø Across time & between entities 16

Constraints 1. Timeliness 2. Cost v Benefit 3. Materiality 4. Trade-offs; balancing 17

The 5 Elements 1. Assets 2. Liabilities 3. Equity 4. Income Definition Recognition Criteria 5. Expenses 18

1. Asset definition Para 49 a Result of past event Control Expected economic benefits 19

2. Liability • Definition: AASB 137 & Framework Para. 49 b PAST PRESENT FUTURE • Event • Obligation • Outflow 20

3. Definition of Equity Para. 49 c Assets Liabilities E q u i. Residual t Interest y 21

Para 70 a Liabilities decreases Inflows Assets E q u i t y Increases 4. Definition of Income 22

Assets Liabilities Outflows E q u i t y decreases Para 70 b Increases 5. Definition of expenses 23

Recognition of Elements of Financial Statements 2. Measured Reliably? 1. Is it Probable FEB with flow to entity? Financial Statements Para. 83 If it meets definition then ASK… 24

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Classification (AASB 101) How should each element classify (group) items? • Assets & Liabilities: – – By nature Current/non-current • Equity: – By source (contributed or earned) 1. 2. 3. • Contributed equity (Share capital) Reserves Retained earnings Income: – By nature • Expenses: – By nature or function BFA 201_13 26

Measurement How should each element be measured? • What’s the value? 1. Initially? 2. Subsequently? Different measurement bases: • Historical cost • Current cost • Realisable value (Fair value; MV; NRV) • Present value 27

Measurement of assets and liabilities • Main measures cost & fair value for example: – AASB 116 Property, Plant & Equipment • Initially recognised at cost, but choice of revaluation model later – AASB 9 Financial Instruments • Financial assets measured at fair value 28

Accounting Standard AASB 13 • May 2009, IASB Exposure Draft Fair Value Measurement = AASB ED 181 in June 2009 AASB 13 Sept 2011 • Applicable from 1 st Jan 2013 (can be adopted early) • Why was it issued? – To establish a single source of guidance, and to reduce complexity and improve consistency in application – To clarify the definition of fair value in order to communicate the measurement objective more clearly – To enhance disclosures so that users can assess extent to which it is used an how it is derived 29

Parts of AASB 13 • Document consists of: – Accounting standard – Appendix A: Defined terms – Appendix B: Application guidance – Above are all integral to the standard – Basis for Conclusions – Illustrative Examples 30

AASB 13 • Objectives (Para. 1): – To define fair value; – To provide a single standard for measuring fair value; – To require disclosure about measurement • Application • Definition ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’ (Para. 9) 31

Application of AASB 13 • Applies to non-financial assets, liabilities and an entity’s own equity instruments • 4 steps to make a fair value measurement: – The particular asset or liability that is being measured; – For non-financial assets, the valuation premise that is appropriate for the measurement; – The principal (or most advantageous) market for the asset or liability; – The valuation techniques appropriate 32

Application to Non-Financial Assets • AASB 13 Para. 11: characteristics • Key issues: location, condition, restrictions, standalone or group • Valuation premise is ‘highest & best use’ of asset (Appendix A – def. ) • Principal or most advantageous market Para. 16, Appendix A • Valuation technique, Para. 61 – Hierarchy of inputs - Levels 1, 2 & 3 33

Lecture Case Study 1 • Entity acquires land on which a factory stands • Currently used for industrial use • Nearby sites have been developed for residential use for high-rise apartments • Recent zoning changes mean that the land could be now used for residential purposes • How would the highest and best use of the land be determined? 34

Lecture Case Study 1 (cont. ) • Comparing the results from possible uses: – Use land as is currently i. e. as a site for the factory • Valuation premise would be the fair value of both the land the factory – The land could be made into a vacant site for residential purposes • Valuation premise would be just the land as a standalone asset. The factory would have to be demolished and the fair value of the land would be calculated net of the cost of destruction of the factory and other costs of conversion to a vacant site 35

Application to Liabilities • Only 3 steps in measurement process • Highest and best use does not apply • May refer to the value of a corresponding asset in measuring fair value • Present value techniques may be useful where asset is not held by other entity • Non-performance risk (including own credit risk) also included 36

Lecture Case Study 2 • Alpha Co and Beta Co each enter into a contractual obligation to pay cash ($500) to Gamma Co in 5 years. • Alpha Co has a AA credit rating and can borrow at 6%p. a. , and Beta Co has a BBB credit rating and can borrow at 12%p. a. • What is the fair value of each entity’s liability? 37

Lecture Case Study 2 (cont. ) • Alpha Co will receive about $374 in exchange for its promise (the present value of $500 in 5 years at 6%). • Beta Co will receive about $284 in exchange for its promise (the present value of $500 in 5 years at 12%). • The fair value of the liability to each entity (ie the proceeds) incorporates that entity’s credit standing. 38

Disclosure Requirements Para. 91 -99 • Para 91: An entity shall disclose information that enables users of its financial statements to assess both of the following: – for assets and liabilities that are measured at fair value on a recurring or non-recurring basis … the valuation techniques and inputs used to develop those measurements – for recurring fair value measurements using significant unobservable inputs (level 3), the effect of the measurements on profit or loss …. . for the period 39

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