The Iasb Framework

The IASB Framework sets out the concepts and principles underlying the preparation of financial statements for presentation to a wide range of users. This framework acts as a guideline, a regulation and sets out the scope of International Accounting Standards. It represents the very foundation of international financial reporting and represents the basis from which all IASs emanate.

The framework consists of the following chapters:

· Objectives of financial statements;

· Qualitative characteristics that determine the decision usefulness of information contained in the financial statements; and

· Definition, recognition and measurement of elements from which financial statements are constructed.

Objectives of financial statements

The objective of financial statements is to provide information on:

· Financial position;

· Changes in financial position; and

· Financial performance of an organisation

Financial Position

Information on the financial position of an organisation include information about economic resources controlled by the entity, the financial structure, the liquidity and solvency position of the entity and also the ability of that entity to adapt to a changing and dynamic environment.

Economic resources controlled by an entity

Information about economic resources under the entity's control will help assess the amount of future economic benefits that will probably be generated. Disclosing such information will assist the user in taking economic decisions. For instance, an investor will be in a better position to take more informed investing decisions; an employee may be more aware about any scope for salary increases and bonuses.

Financial structure

This refers to the mix of debt and equity of an entity. The more debt a company takes on, the greater the financial risk and hence the risk of bankruptcy. The financial structure enables users to assess:

· The extent to which the company can obtain additional external sources of funds in the form of debts;

· How profit is being distributed in the form of dividend and interest; and

· The company's ability to settle its existing debts

Liquidity and solvency

Information about liquidity helps to determine whether the company settle its short term debts as and when they fall due. Solvency is all about the entity's ability to settle its long term debts as and when they fall due.

Changes in financial position

This provides information about the way cash is used or generated from operating, investing and financing activities. It allows the user to assess the cash adaptability of the organisation and the way in which cash is distributed.

Financial Performance

The net assets of an organisation indicate profit levels. Increases/decreases in net assets result in increases/decreases in profits. Information about financial performance of an organisation is essential since it helps the user:

· To assess economic benefits generated from its existing resource base; and

· To determine the efficiency with which the entity might employ additional resources

Qualitative Characteristics

The information contained in the financial statements should be relevant, reliable, understandable and comparable.

Relevance

Information is relevant so far it has the impact of influencing the decisions of users of financial statements. Information can be relevant by nature and by amount. Furthermore the timely nature of information is fundamental in determining its relevance. Materiality is a particular characteristic often associated to relevance. Materiality may be assessed by the impact information can have on the decisions of users. Past and current information may be of predictive value to the user while future information will be of confirmative value and hence all essential/relevant for the user.

Examples of relevance:

A key personnel staff is a close family member to the managing director of the company. Despite the fact that there might not be any transactions between the company and the staff, the nature of the related party relationship should be disclosed as this is purely relevant information by nature.

The resignation of Jose Mourino as manager of Chelsea has definitely been a relevant and important information in Premiership football. However, had the information been concealed and disclosed much later after his resignation, this information would not have had the same impact.

Disclosing information about the risks associated with financial instruments is also relevant. IFRS 7 Financial Instruments: Disclosure, highlights the importance of disclosing the risk level of financial instruments and also requires organisation to explain their policies towards managing such risks.

Disclosing and computing separate EPS for discontinued operations and for the whole operations (that is both continued and discontinued) is much relevant (IAS 33)

Reliability

Reliability is enhanced when information is free from errors/bias and any other form of misstatements. The elements contained in the financial statements faithfully represent the transactions that have occurred.

Users express greater confidence in the contents of financial statements when:

· The financial statements are free from mistakes, errors, omissions and other misstatements;

· Transactions are faithfully represented and are correctly recorded as assets, liabilities, incomes or expenses in the financial statements;

· Information is free from bias;

· Financial statements are prepared under conditions of uncertainty;

· Information is complete and prudence is applied; and

· Financial statements are prepared within the bounds of materiality.

Scenario 1- Faithful representation

Forest Ltd is a major producer and supplier of plywood. The company enters into a sale and repurchase agreement with Timber Ltd. Forest sells wood to Timber for $8m and purchases it for $10m in 4 years. Describe the nature of such a transaction.

Understandability

The IASB Framework emphasises on the need for information in financial statements to be clearly explicit since these are General Purpose Financial Statements (IAS 1, Presentation of Financial Statements). It is however expected that users have relatively sound business knowledge. Understandability is the quality of information that enables users to comprehend its meaning. It is essential that any relevant information; whatever be its complexity; be included in the financial statements. Understandability is enhanced through aggregation, categorisation, classification and presentation of financial information.

Comparability

A key characteristic of qualitative information is comparability. Financial statements should be prepared on grounds that will enable their comparison over time and across boundaries (firms within the same industry). The adoption of similar accounting policies and application of IASs/IFRSs facilitates comparison.

Definition, Recognition and Measurement of elements

The financial statement is made up of five key elements: Asset, Liability, Income, Expense and Equity.

Definition – Asset

An asset is a resource controlled by an entity as a result of a past event from which it is probable that future economic benefits will flow.

In order to qualify as an asset, the item should not result in any form of cash outflow. Besides, ownership is not a necessary criterion for access to future economic benefits.

An item is recognised as an asset when

· It can be reliably measured at cost;

· It is probable that future economic benefits will flow to the entity

Definition – Liability

A liability is a present obligation arising from a past event, the settlement of which results in an outflow of resources embodying future economic benefits.

At no point in time will a liability give rise to an inflow of resources. The occurrence of liability may be viewed as a transfer of resources at the time of settlement.

An item is recognised as a liability when:

· It can be reliably measured at cost;

· It is probable that the settlement of the transaction will result in an outflow of resources embodying future economic benefits

Income, Expenses and Equity

The framework defines income as increases in economic benefits arising from the enhancement of assets or reduction in liability that results in increases in equity other than those arising from contributions from equity participants.

Increases in net assets lead to income so far those increases do not arise from any form of capital contribution (issue of shares).

Expenses are decreases in economic benefits in the form of depletion of assets or increase in liabilities that result in decreases in equity other than those arising from distribution to equity participants.

A reduction in net assets give rise to an expense so far that reduction is not attributed to any form of distribution to equity participants (dividends).

Equity/ Net Assets is the residual interest in the net assets of an entity after having deducted all liabilities. Equity consists of ordinary share capital and reserves. (Movements on reserve accounts are reflected in the statement of changes in equity)

Home Activity 1: Outline the importance of the IASB Framework

Measurement Bases

The IASB Framework recognises the following measurement bases:

· Fair value measurement;

· Historical convention;

· Current value approach;

· Future value measurement; and

· Present value method

One fundamental aspect of the IASB framework is that it lays much emphasis on the adoption of a balance sheet approach. This approach implies that decisions should be taken on the basis of the equity position of the organisation; hence the net assets.