In July 2013 the International Accounting Standards Board (IASB) issued a discussion paper on a new version of its conceptual framework, which provides the fundamental basis for development of International Financial Reporting Standards (IFRS).
The discussion paper gives users and preparers of financial statements an opportunity to offer input into the direction of financial reporting standards. The paper sets out the fundamental principles of accounting necessary to develop robust and consistent standards. While it lacks the immediacy of other IASB proposals, it will nevertheless be a significant long-term influence on the direction that accounting standards will take.
The paper introduces revised thinking on the reporting of financial performance, the measurement of assets and liabilities, and presentation and disclosure. The paper proposes that the primary purpose of the framework - which underpins the accounting standards - is to identify consistent principles that the IASB can use in developing and revising those standards. The framework may also help in understanding and interpreting the standards.
The IASB framework was originally published in the late 1980s. In 2010 two chapters of a new framework were issued: Chapter 1, The Objective of General Purpose Financial Reporting, and Chapter 3, Qualitative Characteristics of Useful Financial Information. There are no plans for a fundamental reconsideration of these chapters. The concept of a reporting entity is not considered in the discussion paper because the exposure draft of 2010 is to be used, with related feedback, in developing guidance in this area.
The discussion paper proposes to redefine assets and liabilities as:
- An asset is a present economic resource controlled by the entity because of past events.
- A liability is a present obligation of the entity to transfer an economic resource because of past events.
An 'economic resource', it should be noted, is a right, or other source of value, that is capable of producing economic benefits.
Currently the definitions of assets and liabilities require a probable expectation of future economic benefits or resource outflow. The IASB's initial view is that the definitions of assets and liabilities should not require an expected or probable inflow or outflow as it should be sufficient that a resource or obligation can produce or result in a transfer of economic benefits. Thus, a guarantee could qualify as a liability even though the obligation to transfer resources is conditional. However, the measurement of an asset or liability will be affected by the potential outcome. The IASB still believes that a liability should not be defined as limited to obligations that are enforceable against the entity.
Under the discussion paper, constructive obligations would qualify as liabilities. Liabilities would not arise where there is an economic necessity to transfer an economic resource unless there is an obligation to do so. Thus a group reconstruction would not necessarily create a liability.
However, the IASB believes that certain avoidable obligations could qualify as a liability - for example, directors' bonuses depending on employment conditions. No decision has been made on whether the definition of a liability should be limited to obligations that the entity has no practical ability to avoid or should include conditional obligations resulting from past events.
The discussion paper sets out that the framework's definition of control should be in line with its definition of an asset. An entity controls an economic resource if it has the present ability to direct the resource's use so as to obtain economic benefits from it. The exposure draft on revenue recognition uses the phrase 'substantially all' when referring to benefits from the asset but the IASB feels this phrase in this context would be confusing as an entity would recognise only the rights which it controls. For example, if an entity has the right to use machinery on one working day per week, then it should recognise 20% of the economic benefits (assuming a five-day working week) as it does not have all or substantially all of the economic benefits of the machinery.
The discussion paper proposes that equity remain defined as being equal to assets less liabilities. However, the paper does propose that an entity be required to present a detailed statement of changes in equity that provides more information regarding different classes of equity, and the transfers between these different classes.
The distinction between equity and liabilities focuses on the definition of a liability. The current guidance on the difference between equity and liability is complicated. The paper identifies two types of approach: narrow equity and strict obligation.
The narrow equity approach treats equity as being only the residual class issued, with changes in the measurement of other equity claims recognised in profit or loss.
Under the strict obligation approach, all equity claims are classified as equity with obligations to deliver cash or assets being classified as liabilities. Any changes in the measurement of equity claims would be shown in the statement of changes in equity.
If the latter approach were adopted, certain transactions (eg the issuance of a variable number of equity shares worth a fixed monetary amount) currently classed as liabilities would not be so designated because they do not involve an obligation to transfer cash or assets.
The IASB has come to the view that the objective of measurement is to contribute to the faithful representation of relevant information about the resources of the entity, claims against the entity and changes in resources and claims, and about how efficiently and effectively the entity's management and governing board have discharged their responsibilities to use the entity's resources. The IASB believes that a single measurement basis may not provide the most relevant information for users.
When selecting the measurement basis, the information that measurement will produce in both the statement of financial position and the statement of profit or loss and other comprehensive income (OCI) should be considered. Further, the selection of a measurement of a particular asset or a particular liability should depend on how that asset contributes to the entity's future cashflows and how the entity will settle or fulfil that liability.
Narrow and broad
The current framework does not contain principles to determine the items to be recognised in profit or loss, and in OCI and whether, and when, items can be recycled from OCI to profit or loss. In terms of what items would be included in OCI, the paper proposes two approaches: 'narrow' and 'broad'.
Under the narrow approach, OCI would include bridging items and mismatched remeasurements. OCI would be used to bridge a measurement difference between the statement of financial position and the statement of profit or loss. This would include, for example, investments in financial instruments with profit or losses reported through OCI. Mismatched remeasurements occur when the item of income or expense represents the effects of part of a linked set of assets, liabilities or past or planned transactions. It represents their effect so incompletely that, in the opinion of the IASB, the item provides little relevant information about the return the entity has made on its economic resources in the period.
An example is a cashflow hedge where fair value gains and losses are deferred in OCI until the hedged transaction affects profit or loss. The paper suggests that under the narrow OCI approach, an entity should subsequently have to recycle amounts from OCI to profit or loss; and under the mismatched remeasurements approach the amount should be recycled when the item can be presented with the matched item.
The issue that arises here is that, under the narrow approach, the treatment of certain items would be inconsistent with current IFRS - eg revaluation gains and losses for property, plant and equipment.
The paper also sets out a third category - 'transitory remeasurements'. These are remeasurements of long-term assets and liabilities that are likely to reverse or significantly change over time. These items would be shown in OCI - for example, the remeasurement of a net defined pension benefit liability or asset. The IASB would decide in each IFRS whether a transitory remeasurement should be subsequently recycled. However, the IASB has not yet determined which approach it will use.
Recognition and derecognition deals with the principles and criteria for assets and liabilities to be included or removed from an entity's financial statements. The paper sets out to bring this into line with the principles used in IASB's current projects. It proposes that assets and liabilities should be recognised by an entity, unless that results in irrelevant information, the costs outweigh the benefits, or the measure of information does not represent the transaction faithfully enough.
Derecognition is not currently addressed in the framework and the paper proposes derecognition should occur when the recognition criteria are no longer met. The question for the IASB is whether to replace the current concept based on the loss of the economic risks and benefits of the asset with the concept based on the loss of control over the legal rights comprised in the asset. A concept based on control over the legal rights could result in several items going off balance sheet.
Proposed revisions to the disclosure framework include the objective of the primary financial statements, the objective of the notes to the financial statements, materiality and communication principles. The IASB has also identified both short-term and long-term steps for addressing disclosure requirements in existing IFRS.
These proposals are an attempt to make the conceptual framework a blueprint for developing consistent, high-quality, principles-based accounting standards. It is important that there is dialogue about the whole of IFRS and for the IASB to achieve buy-in to its core principles by enabling constituents to help shape the future of IFRS.
Graham Holt is associate dean and head of the accounting, finance and economics department at Manchester Metropolitan University Business School