This article was first published in the October 2013 International edition of Accounting and Business magazine.
The International Accounting Standards Board is revising its conceptual framework and has issued a discussion paper on the issues it is considering in that review. The IASB has had a framework for the preparation and presentation of financial statements since 1989, and is part-way through replacing this with the conceptual framework. This consultation covers the remaining areas.
The framework sets out the important issues underlying the standards, but it is not a standard, and companies do not have to follow it to comply with International Financial Reporting Standards (IFRS).
Why is the framework important?
If there is no standard to cover an issue, then companies can look to the framework among other things to work out what to do. But its main use has been to guide the IASB in developing new or revised standards.
Many see the addition of the ‘conceptual’ tag to the framework as proof that IFRSs are too ‘theoretical’. For others the framework gives consistency and coherence in the standards and that is their best defence against lobby groups on particular issues.
It is hard not to look at the framework without thinking how it impacts current debates over standards and how standards might develop.
The sections on the objectives and characteristics of reporting were recently revised in collaboration with the Financial Accounting Standards Board (FASB), the US standard setter, but the new sections will be done by the IASB alone.
Definitions of assets and liabilities
Some aspects of the definition of assets do not seem to be changing significantly – namely, control and the capability to produce future economic benefits. However, the definition of an asset will not include a reference to the probability of those benefits. Nor will this be reflected in a recognition threshold. So when there is only a low probability of benefit or great uncertainty, then that will only be reflected in the measurement of the asset or its exclusion on the grounds that the resulting information is not useful. How might this impact the treatment of internally generated goodwill, contingent assets or mineral reserves for example?
On liabilities the framework tries to keep the definition symmetrical with that of an asset, which seems helpful. In deleting probability from the definition and recognition, comparable issues around uncertain and conditional liabilities are raised. Should only unconditional liabilities be included, or ones where there may be conditions but there is no practical ability to avoid them? Or should the existence of conditions not affect their recognition? The discussion paper looks at examples from its emissions trading project to illustrate different outcomes from those decisions. Likewise with options – how much should economic compulsion to exercise certain options affect whether there is a liability or not? This could affect options to extend leases (in the current exposure draft) or redeemable shares with ‘step up’ dividends.
Measurement: fair value or historical cost?
This is currently a gap in the framework and the issue is very prominent in much of the debate about IFRS in the light of the financial crisis. The discussion paper indicates that the IASB will continue with a mixed measurement model and identifies three measurement bases:
- current market prices, including fair value
The decision about when to use one or another will depend on the relevance of the information to users both in the balance sheet and the income statement. It will also depend on how the asset will be realised or the liability settled and on cost/benefit grounds. It seems difficult to argue with this or see much change in the cost/fair value boundary as a result.
Cashflow-based measures (such as those used for provisions, pensions and deferred tax) should reflect variations in expected cashflows, time value of money, risk premium (including an entity’s own credit risk in liabilities) and any liquidity effect. Own credit risk is not always recognised (for example, in pension liabilities), nor is the time value of money for deferred tax. So this might imply changes are needed in these standards.
Profit and comprehensive income
What has not changed is that the framework remains driven by assets and liabilities and that equity is the residual difference, and gains and losses represent changes in them.
The other big issue in this project is what gains and losses should be part of profit or loss and what should go to other comprehensive income (OCI)? Should items that go to OCI be recycled into P&L when realised? Treatments at stake might include cashflow hedging, revaluation of property, actuarial gains and losses on pension liabilities, the new fair value through OCI category in IFRS 9 and changes in discount rates in IAS 37.
The default treatment will be to P&L, but there will be cases where an IFRS could put certain items through OCI. If so, recycling will be expected. The categories of such items might be framed more narrowly as measurement mismatches (for example, between a balance sheet at fair value and P&L based on cost), or defined more widely to add transitory longer-term remeasurements. Cashflow hedging or the fair value through OCI from IFRS 9 would qualify either way, but many items currently allowed through OCI would only qualify if the IASB goes for the wider definition (such as revaluations, actuarial gains/losses, changes in own credit and designated equities under IFRS 9).
The discussion paper covers a host of other matters, including the concepts of going concern, the business model and the boundary between what are liabilities and what is treated as equity. It puts forward six principles for better disclosures. Some controversial issues in chapters that have been ‘completed’ are included (see below).
The consultation on this framework is open until 14 January 2014. It is a chance to consider fundamental issues in financial reporting that many claim are changing and not for the better. It is also another battleground to debate the issues in current projects such as leases and financial instruments.
The discussion paper points the way to the resolution of issues where standards are inconsistent. It clearly draws the line under the convergence model with the FASB, even to the extent of inviting comments on the jointly completed sections.
There will probably be an exposure draft of the proposed framework before the final version. But how will it affect IFRS at that point?
The framework will alter the way new and current projects are completed. However, the standards that are inconsistent with the new framework may not be altered right away. Standards like IAS 20 on government grants pre-date and are incompatible with the 1989 framework, but are still in effect today.
Prudence, reliability and stewardship
These concepts from the 1989 framework were dropped in the chapters already completed by the IASB and FASB jointly. The discussion paper reiterates why – prudence and neutrality were considered contradictory. However, Hans Hoogervorst, the IASB chairman, has described the phrase that prudence was caution in the face of uncertainty as ‘pure common sense’. The discussion paper does a better job with reliability, which was replaced by representational faithfulness together with the enhancing characteristic of verifiability. It is most convincing on stewardship, where the word has gone but the concept remains. Indeed, the paper is sprinkled with references to the accountability of management for the resources with which they are entrusted.
Richard Martin is ACCA’s head of corporate reporting