Graham Holt examines whether criticisms that the Conceptual Framework lacks consistency and clarity have been addressed
This article was first published in the January 2016 international edition of Accounting and Business magazine.
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The International Accounting Standards Board (IASB) issued an exposure draft (ED) in May 2015, proposing changes to the Conceptual Framework. The discussion paper’s proposals include a revision of the definitions of the elements in the financial statements, guidance on derecognition, measurement and the inclusion of items in other comprehensive income (OCI). The existing Conceptual Framework has been criticised for its lack of clarity and conceptual guidance, and for not being consistent with the IASB’s current thinking.
Chapter 1 in the ED describes the objective of financial reporting, but most chapters focus on the information provided in financial statements and do not address other forms of financial reports, such as management commentary or interim financial reports.
The ED does not propose changes to the distinction between liabilities and equity, even though existing standards do not apply the definitions consistently and often require greater disclosure of those items classified as liabilities than those as equity. The IASB decided to deal with this issue in its Financial Instruments with Characteristics of Equity research project.
Many respondents to the discussion paper felt that the IASB should define and use the ‘business model’ concept throughout the Conceptual Framework, as the entity’s business model could affect the measurement of assets and liabilities. Other respondents disagreed, saying that referring to the business model could introduce management bias into financial reporting.
The IASB felt that the nature of an entity’s business activities plays different roles in different aspects of financial reporting, so the ED does not include a general discussion of the role of the business model in financial reporting.
However, the ED recognises that when determining a measurement basis for an asset or a liability and related income and expenses, the business model is a factor in estimating how the asset or the liability contributes to future cashflows and whether income and expenses should be included in OCI.
Chapter 1 further identifies the primary users of financial reports as existing and potential investors, lenders and other creditors who cannot require entities to provide information directly to them.
Respondents to the discussion paper had varying views. Some felt that the primary user group was too narrow and should include employees and regulators. Others felt that the definition was too wide and should only include equity holders.
In the view of the IASB, existing and potential investors need similar information and the changes to the objective of financial reporting clarify the need to provide information that helps investors to assess management’s stewardship.
The IASB removed the reference to prudence in the discussion paper because of the possible inconsistency with the concept of neutrality. Some respondents to the paper agreed with this decision because of the lack of understanding of what prudence means and its greater subjectivity. However, many felt that a reference to prudence should be reinstated as prudence is needed to offset preparers’ optimistic bias, and investors are more concerned about downside risk than upside potential.
Exercising prudence aligns the interests of shareholders and managers, and recent financial problems have shown the need for prudence when making estimates.
The concept of prudence is often interpreted as the need for caution in making judgments about losses and liabilities, with less caution required with judgments about gains and assets. Others advocate a concept of prudence that requires more persuasive evidence to support the recognition of gains or assets than of losses or liabilities.
Another view is that a measurement basis should be selected that recognises losses at an earlier stage than gains. Prudence is defined by the IASB as the exercise of caution when making judgments under conditions of uncertainty.
The IASB feels that prudence can help achieve neutrality in applying accounting policies.
Substance over form
The Conceptual Framework does not include an explicit reference to substance over form and the IASB agrees that making this statement explicit would add clarity. As a result, the ED proposes that faithful representation should provide information about the substance of an economic phenomenon instead of merely information about its legal form. The reasoning behind this view is that accounting in accordance with its legal form, even with relevant disclosures, cannot result in a faithful representation if the economic substance of the item is different.
There is no proposal to reinstate reliability instead of faithful representation, because it appears that reliability is linked by users with the level of measurement uncertainty and not with the broader notion set out in the original framework.
The IASB has found that confusion can arise over the existing definitions of assets and liabilities. The current definition of an asset is ‘a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’, and that of a liability is ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’.
It is thought that the explicit reference to the flows of economic benefits blurs the distinction between the resource and the resulting flows of economic benefits, and the term ‘expected’ is often interpreted as a probability threshold.
The IASB proposes the following definitions:
- An asset is a present economic resource controlled by the entity as a result of past events.
- A liability is a present obligation of the entity to transfer an economic resource as a result of past events.
- An economic resource is a right that has the potential to produce economic benefits.
The main changes from the existing definitions are the introduction of a separate definition of an economic resource and the removal of the notion of an expected inflow or outflow of resources. The inclusion of expected flows would have excluded several items that are assets and liabilities, such as written and purchased options.
No major problems have been identified with the definitions of income and expenses. The only changes proposed are to make them consistent with the proposed definitions of assets and liability. Some of the classification requirements of IAS 32, Financial Instruments: Presentation, are inconsistent with the existing Conceptual Framework’s definitions and the proposed definitions of liability and equity.
The recognition criteria in the existing Conceptual Framework is based partially on the probability that any future economic benefit associated with the item will flow to or from the entity. However, some standards do not apply a probability recognition criterion (IFRS 9, Financial Instruments) and those that do use terms that imply different thresholds of probability.
For example, terms such as ‘more likely than not’, ‘virtually certain’ and ‘reasonably possible’ are used in current standards and this can lead to inconsistencies and non-recognition of items. The IASB therefore proposes to base the criteria for recognition on the qualitative characteristics of useful financial information. The criteria therefore are based on relevant information, faithful representation and whether the benefit of the information provided by recognising the asset or liability outweighs the cost of doing so.
The existing Conceptual Framework does not define or describe the occurrence of derecognition and, as a result, the standards have adopted different approaches. The IASB proposes that the accounting requirements for derecognition should aim to represent faithfully both the assets and the liabilities retained, and the changes in the assets and the liabilities as a result of the transaction.
An issue arises where an entity disposes of only part of an asset or a liability; for example, where trade receivables are sold with recourse. The ED does not advocate a control approach or the risk-and-rewards approach to derecognition in every circumstance, but describes the alternatives that are available.
The IASB feels that the best way to classify the measurement bases is using historical cost or current value. Cashflows are often used to estimate the measure of an asset or a liability, but the ED does not identify cashflow techniques as a separate category of measurement. The description of fair value in the ED is consistent with that in IFRS 13, Fair Value Measurement.
The IASB felt that conceptual guidance on the use of the statement of profit or loss and OCI is urgently needed. However, no single characteristic can be used to separate items of income and expenses into two clear-cut categories, primarily because there are many facets of an entity’s financial performance.
Therefore, the IASB has concluded that it is not possible to define, or precisely describe, in the Conceptual Framework when an item of income or expenses should be included in the statement of profit or loss or OCI. Instead, high-level guidance is given.
The statement of profit or loss should be as inclusive as possible and only where there is a valid reason should an item be excluded. Only in limited circumstances, such as where the relevance of information is improved, should income and expenses be included in OCI. The IASB proposes to specify that only income and expenses related to remeasurements should be included in OCI.
There is a presumption that income and expenses included in OCI must subsequently be reclassified to profit or loss where it enhances the relevance of the information. If this is not the case, then reclassification will not occur.
Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan Business School
CPD technical article
"The IASB removed the reference to prudence in the paper because of the possible inconsistency with the concept of neutrality"