A Review of the Conceptual Framework for Financial Reporting

A review of the conceptual framework for financial reporting

Discussion Paper issued for comment by the International Accounting Standards Board

Comments from ACCA 14 January 2014

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Further information about ACCA’s comments on the matters discussed here may be obtained from the following:

Richard Martin Head of Corporate Reporting Email: [email protected]

1 ACCA welcomes the opportunity to respond to the above discussion paper. Our Corporate Reporting Global Forum of members has considered the proposals, and its views are reflected in the following general and specific comments.

GENERAL COMMENTS

ACCA supports the review and a revision of the conceptual framework (CF). Many standards have been issued or had major revisions since the original framework was issued. The framework should be updated from time to time to reflect the experience of these major developments.

The next step in the development of the new framework should be the exposure of the whole document including a reconsideration of the chapters regarded currently as completed. It is very important that some amendments are made to those ’completed’ chapters, which should include coverage of the concepts of prudence and accountability. Prudence is built into the existing IFRS in a number of ways and has implications for the draft guidance set out in the discussion paper on the recognition of assets and liabilities. Given this, it would be wrong for the concept not to be addressed and explained in the conceptual framework. Accountability is referred to but it needs to be promoted to a position of at least equal prominence to the making of investment or credit decisions.

There are a number of important areas, for example on the unit of account issue, derecognition and disclosures, where no concept or principle seems to be included in the framework, but it is proposed to be left to standard-by-standard decisions. This seems inherently unsatisfactory for the CF. While we agree that there needs to be a degree of flexibility for the IASB in the application of the framework, there a number of instances where we consider more could be done even if only in the identification of the issues that will need to be considered in that standard-level decision.

2 On the other hand the discussion paper, in places, includes too much material which might then raise issues of consistency with the standards or would be better in those standards. Section 5 on the equity/liability distinction falls into this category, as does much of Section 8 on the presentation of P&L and other comprehensive income (OCI).

The new definition of assets, in particular, seems to extend the scope of items that might be included. If that definition is to stand, then clearer recognition filters will be needed to ensure that very uncertain, improbable or hard to measure items are not included in financial statements.

A more coherent definition of liabilities is needed that brings together the approach to conditional liabilities, constructive liabilities and the implications of economic compulsion.

The principles for choosing different measurement bases are one of the major gaps in the current framework. So remedying that with the sort of material which is included in Section 6 would be very welcome. We very much support a mixed measurement model, where the measure should reflect the likely realisation/settlement of the item. Some further elaboration of the principles of measuring cost and current exit values should be added.

Clear principles for the presentation of items as either OCI and profit or loss are needed, as the rationale for the differing treatment is difficult to discern.

3 SPECIFIC COMMENTS

We now comment on the specific questions raised as follows:

Q1. Purpose of CF – to assist IASB in standard setting, but they may depart from aspects

We agree that the primary purpose of the CF is to help IASB set or revise standards in as consistent and coherent a way as possible. We agree that with suitable explanation the IASB may depart from some aspect of the CF in setting or revising standards, because some aspects of the framework represent a balance between different characteristics or objectives and inevitably there may be some that are given more weight than others.

We also agree with para 1.22 that the development of a new CF should not necessarily require amendments or revisions to existing standards simply because they may not be entirely consistent with a new CF. IASB could usefully prepare for the next consultation, an assessment of the impact of any proposed changes to existing standards. This would help give constituents a better understanding of the proposed CF and the practical implications of those proposed changes which incorporate subtle but potentially significant amendments to the existing wording.

As a secondary purpose, the CF will be used by preparers in relatively few cases to help interpret standards and help decide on treatments where there is no standard to cover the case. Unlike paragraph 1.29 we doubt that there should be aspects of the CF that should be relevant to the primary but not this secondary purpose. It would be potentially confusing in a CF to have these different elements.

Q2. New definitions of assets, liabilities and economic resources

The new definitions seem clear and more consistent between assets and liabilities.

4 Q3. Uncertainty about economic benefits

We agree there should be no probability threshold in the definition of assets or liabilities.

However, removing the probability element of the definition of assets and the definition of economic resource potentially means that items currently not recognised as assets – such as the workforce, research and internally generated intangibles – may fall within this definition. From considerations of relevance and prudence, some very uncertain assets and liabilities are better excluded from financial statements. It is not sufficient for these considerations to be reflected simply in their measurement. Firstly it is a burden to ask for these to be included by being measured at very small or even immaterial amounts. Secondly the resulting amounts may be often difficult to understand. It is important therefore that there are recognition criteria that on the grounds of relevance to users filter out some of these assets and liabilities of great uncertainty, very remote probabilities or based on very unreliable measures (see also Q8).

We agree that there may be cases where there is uncertainty over whether an asset or liability exists albeit that it can sometimes be difficult to distinguish existence from measurement uncertainty. However where there is existence of uncertainty such assets or liabilities should not be included in financial statements unless they are virtually certain, but may instead be dealt with by disclosures.

Q4. Other elements

We do not see that one part of the financial statements should be given greater significance than another. So while we agree that income and expenses should be defined in terms of increases or decreases in assets and liabilities as proposed, it is important that assessments of the relevance of the resulting information are focussed on the profit and loss account as well as on the statement of financial position.

Equity is defined as the residual, with which we agree.

The other elements that may need to be defined are  contributions or distributions of equity

 capital maintenance adjustments.

5  cash inflows and outflows

Q5. Constructive obligations

We support the retention of the existing definition of a constructive obligation.

While we agree with much of the explanation of the concept in paragraphs 3.50 to 3.54, IASB should consider how much of it would be needed in the CF rather than in a standard or standards dealing with these liabilities. IAS37 already includes much explanatory information and examples and users might be confused by much further material in the CF. Probably any further explanation in the CF should not go far beyond the provisions of paragraph 3.50.

Q6. Conditional obligations

We agree that obligations which are conditional on someone else’s actions should be recognised – for example guarantees, claims under insurance policies or options for others etc.

For obligations which might depend on the reporting entity’s own actions, we prefer View 2, i.e. to recognise only those that are practically unconditional (taken as no practical ability to avoid). Further elaboration of this phrase will probably be needed.

Our main concerns with View 3 relate to:  Scope for subjectivity in the measurement of the greater number of obligations that would result  Need for more standards- level guidance on measurement  Additional costs in measuring a larger number of sometimes hard-to-measure obligations

We did not find the scenarios (between pages 54 and 60) overly helpful as they give little illustration of the difference in principle between View 2 and View 3.

We feel there is further scope for achieving greater coherence between the definitions of conditional and constructive obligations.

Q7. Other comments on asset/liability guidance

We agree with the guidance on the meaning of an economic resource. 6 We agree also with the proposed definition and guidance on the meaning of control of an economic resource. There are aspects of IFRS10 which might be more widely applicable which seem inadequately discussed in the paper – for example the agency/principal issue.

We support the proposed guidance in 3.102 on reporting the substance of contractual rights and obligations.

We note that, in effect, the proposed framework is to include no principles on the role of economic compulsion in assessing the substance of contractual obligations, but instead this will be determined on a standard-by-standard basis. That seems unsatisfactory in principle. The effect of obligations where there is no practical ability for the entity to avoid a transfer of resources is an integral part of the definition of a liability discussed under Q5 and 6 above and should be the basis for a concept or principle on this issue too. We note that 3.45 would seem to imply that it is not currently intended to be the basis of a constructive obligation. Greater clarity is needed in this regard.

We agree with the principles set out in 3.111 on accounting for executory contracts.

Q8. Recognition

Given the elimination of probability thresholds from the definition of assets and liabilities the recognition tests are important to exclude assets and liabilities where the measurement is too unreliable or the information would not be relevant.

We agree with the views in 4.24 and 4.25 and the indicators in 4.26, except that we would like to see the consideration of relevance in 4.26(a) to refer specifically not only to the asset or liability but also to the income or expenses resulting from changes in those assets and liabilities.

Prudence needs to be reflected in recognition criteria and in particular more caution needs to be applied in the recognition of assets than liabilities.

Q9. Derecognition

The approach to derecognition set out in 4.50 is a reasonable one and the choice of possible treatments seems right. These possible treatments would however produce very different results in the financial statements; the paper proposes to leave the choice as between different alternatives to the specific standards. This all seems less 7 than satisfactory in a conceptual framework. In our view the framework should at least set out the sort of considerations that would influence the choice between the different options. By way of example, on the issue of partial or full derecognition, the material in 9.38 to 9.41 provides the sort of considerations that would be involved in the choices.

Q10. Equity and liabilities

(a) We agree that the existing definition of equity should be retained as the difference between assets and liabilities.

(b) Therefore in principle the definition of a liability should be used to distinguish equity and liabilities. There may be difficult cases as a result and the DP discusses some of these including obligations to deliver shares up to a fixed amount of cash or other assets. On the other hand we are not sure that much change in the current boundary set by IAS32 is desirable. Entities with complex capital structures will always present issues for investors in estimating different rights and so a clear definition and disclosures may be the best answer. Investors also have the assistance of the diluted earnings per share figures to highlight cases where the impact of some of these complexities might be very significant.

Given the going concern assumption that is made in preparing accounts, obligations that will only arise on liquidation should not be treated as liabilities.

(c) Whether there need to be distinctions between primary and secondary forms of equity and any proposals on measurement and recognition proposed, all seem issues better dealt with if needed in a standard not in the CF.

We are not sure that this principle of treating the most subordinated class of instruments as equity will be very helpful in portraying relevant information to users. As noted above, entities with unusual or complex capital structures need users to make a careful analysis of rights and obligations. If there is a liability as defined then it needs to be shown as such. The most subordinated liability (if it can be identified) may be a buffer against losses for other creditors, but there may still be no entitlement to surplus assets or being the owners of the entity which would normally be associated with equity. Different presentation possibilities may help to communicate the economic reality without infringing on the basic definition of a liability

Q11. Measurement bases

8 We broadly agree with the preliminary views on measurement bases stated in paragraph 6.35. (a) We agree with the proposed objective of measurement as providing relevant information both for showing the performance of the entity as well as its financial position.

(b) We agree that a single measurement basis will not always be sufficient to provide the most relevant information.

(c) We very much agree that the resulting information, both in the income statements and in the statement of financial position, needs to be considered.

(d) How assets will contribute to future cash flows and how liabilities will be settled should be a key element in determining the appropriate measurement basis. However it is not always clear at the time of preparing the financial statements exactly how these things will come to pass. Probability considerations may need to be considered. The business model concept may help to discriminate the likely outcomes. Some assets and liabilities may be held both for collection and for sale for example.

(e) While the variety of measurements and changes in those should be no more than is necessary, the use of the most suitable measure should not be restricted.

(f) We agree that the benefits of a measurement basis need to justify its cost.

9 Q12. Measurement of assets

We agree with the thinking behind (a) to (c). We support the ‘business model’ approach of considering how the asset is likely to be realised. For the cost-based measures to apply, however, there may need to be reference to both the intention and the ability to hold the asset to be settled according to its terms.

At first sight inventories might seem to be in a current exit price category as they are intended to be sold. In our view, however, inventories in most cases are used in combination with other assets – such as manufacturing assets, retail stores or customer relationships – and this would put them on a cost based measure. We have noted some confusion has arisen over this and so the wording of (b) needs to be reconsidered and a reference to held for trading and a business model of buying and selling on active markets needs to be included.

As noted above there may be assets which may be held for more than one purpose and the framework seems unclear on how these cases should be dealt with.

On (d), where an entity charges for the use of assets, it is not the significance of the individual asset which is important in guiding measurement towards a current value rather than historical cost. The key factor is whether the asset is held either for the collection of the usage income, or for sale, or for both. We therefore see little reason for the CF to differentiate such assets.

Q13. Measurement of liabilities

We broadly agree with the preliminary views expressed. However the phrase ‘stated terms’ in (a) may need to be altered – defined benefit pension liabilities have stated terms but the amounts are very uncertain and so cash flow based measurement would be appropriate.

Q14. Qualifications of the application of cost approach

We agree with that even where assets are held for collection the three factors from paragraph 6.19 may mean that cost based measures may not be appropriate, for example in the case of derivatives.

Q15. Other comments on measurement

10 The framework should address the principles that might guide standards to require measurement on more than one basis. This could be where different measurement bases might be chosen in the income statements from the statement of financial position. It could also be where one basis is used for the primary statements but with disclosure of another basis in the notes.

It is a shortcoming in the discussion paper that it avoids discussion of other measurement bases such as equity accounting as currently used in IFRS (see paragraph 6.5). Readers are left unsure whether these methods might fit within the three way classification in 6.37 or whether in IASB’s view these are measurement bases with no conceptual underpinning.

The paper includes helpful material in paragraphs 6.112 to 6.130 on the factors in developing cash flow based measures. It may be helpful to have some similar exploration of the factors that will need to be considered in determining cost-based measures and current value measures. For example the paper might explain whether there are other current value measures apart from fair value, or whether there may be entry rather than exit based values. The CF appears to make no reference to impairment or depreciation of cost, but these are employed in a number of different standards.

In the discussion of the cash flow based measures there seems no clear conclusion on when or whether standards are likely to reflect entity-specific or market perspectives, nor on the own credit risk issue. No light seems to be shed by the discussion paper as to whether estimates of future cash flows should in principle reflect ‘most likely’ outcomes or a ‘probability-weighted’ estimate.

Q16. Presentation and disclosure

The objectives of the primary statements in 7.18 and in Chapter 1 (OB4) include how efficiently and effectively the resources have been used. We agree that financial statements may help with these but more information might be needed to achieve these objectives to a satisfactory degree than is currently provided – likewise with the notes in 7.35(a) though here efficiency seems to have been lost. Efficiency and effectiveness might imply some consideration of alternative uses for resources and measures of non-financial outcomes from the use of financial resources for example.

11 The financial statements as a whole comprising the primary statements and the notes need clear objectives, but there is no need for separate objectives for the primary statements and for the notes.

Paragraph 7.35 sets out the sort of disclosures that IFRS might require. It would be helpful if the CF would explore some of the principles that should guide the choice of these matters – for example when should reconciliations and roll-forwards be required? Equally some indication would be helpful of when the methods, assumptions and judgements disclosures in paragraph 7.35(e) will be required – presumably when the range of possible outcomes might be great and when significant judgement is likely to have had to have been applied. There is no mention of sensitivity analyses nor when they might needed.

Q17. Materiality

We agree with the text here.

Q18. Communication principles

We agree with the principles of good communication set out in paragraph 7.50 and that they should be applied to disclosures in IFRS.

Q19. Retain profit or loss as a total

We agree that profit or loss for the year is a longstanding and widely-used measure of financial performance and should be retained. A standard on presentation of financial statements, rather than the CF, is probably the place to consider the issues of non-GAAP measures or indeed other sub-totals such as operating profit. We see no reason for the CF to define performance beyond the existing definitions of income and expenses.

Q20. Recycling from OCI to profit or loss Q21. Basis for items to go to OCI

While in principle there are arguments for a single statement of comprehensive income, on the pragmatic grounds of meeting users’ expectations, we support a continuing role for distinctions between profit or loss and OCI. The default position for items of income and expense should be part of profit for the period, unless a standard should require or allow it to go as OCI.

12 It is important for there to be clear principles or criteria for determining what should go to OCI, as key measures such as earnings per share depend on this. For this reason we prefer Approach 2A to 2B. Our concerns are that there are not sufficient principles to distinguish P&L items from OCI under 2B. For example “recognising items as OCI when that might increase the relevance of the information in P&L “is too indefinite as a criterion. Nor does it seem obvious that financial liabilities designated at fair value through P&L would always meet the first test for transitory re-measurements in Flowchart 8.2 “a long term time horizon for settlement”. The risk is that without clear principles OCI will continue to be seen as a ‘dump’ for uncomfortable items.

When the principles for OCI have been established there will be the need for the presentation of items in the income statement to be reconsidered.

When standards are written or revised and there are items that meet the OCI criteria, it will be important that IASB explains why they have or have not been treated as OCI.

In principle all items recorded in OCI should be recycled to profit or loss, unless clearly inappropriate.

Q22. Completed chapters of the Framework

In our view, in any revision of the CF it must be possible to open up the ‘completed’ chapters to ensure that the new whole CF is a consistent and coherent document. The next stage for IASB should be an exposure draft of the whole CF.

Some amendments to these ‘completed’ chapters are clearly needed.

The description of prudence in the former paragraph 37 should be re-integrated into the framework for the reasons stated in 9.20. Prudence is built into the existing IFRS in a number of ways and has implications for the material on the recognition of assets and liabilities in the discussion paper. So it would be wrong for the concept not to be explained and included in the conceptual framework.

Accountability or stewardship needs to be promoted to at least equal prominence as an objective of financial reporting as the making of investment or credit decisions. Paragraph OB4 is a good description of the concept.

13 We note that ‘reliability’ rather than ‘faithful representation’ is the formulation more widely accepted – for example in the framework for integrated reporting.

In our view there should be a specific reference to substance over form in the framework and not just in the basis of conclusions.

Q23. Business model

We agree that how a business operates can have an impact on the information that will be most relevant to users. So the business model is a helpful concept and as noted above may affect the choice of measurement basis for assets and liabilities and also the choice of P&L or OCI. ‘Business model’ should be included in the CF though it may not need a definition given that IFRS9 has been able to incorporate the concept and the phrase without one.

Q24. Unit of account

The unit of account issue may be the best place in which the concepts guiding when contractual rights and obligations need to be ‘bundled’ or ‘unbundled’. This seems not covered at present. The issue has arisen in all the current major standards projects, for example in IFRS 9 and in revenue from contracts with customers. The proposals for a new leasing standard have put greater emphasis on assets as a bundle of different rights including the right of use. This has made the unit of account issue in that regard a more significant one.

Q25. Going concern

We have nothing to add to the guidance in paragraph 9.42 to 9.44 on this subject.

14 Q26. Capital maintenance

This is inadequately dealt with in the paper. If there could be items required as capital maintenance adjustments, that means that the boundary between income and expenses on the one hand and equity movements on the other is incomplete. Changes in assets and liabilities could be either income, expenses, changes in equity or capital maintenance adjustments. Section 8 raises this in relation to revaluations of property, plant and equipment for example.