Semester 1 Week 4 PP (The Conceptual Framework)

Question 1

Who uses financial statements?

Answer 1

Potential investors
Current shareholders
Lenders/banks
Suppliers
Customers
Government bodies

Question 2

What impacts financial reporting?

Answer 2

Question 3

What is the Companies Act 2006?

Answer 3

Main piece of legislation regulating companies in the UK.
Companies required to maintain “adequate” accounting records; meaning sufficient to:
Show and explain company’s transactions
Disclose, with reasonable accuracy, the company’s financial position at any time
Enable the directors to prepare the annual financial statements.
All companies must maintain:
Entries showing all money received and expended (with explanations)
A record of the assets and liabilities
Companies dealing in goods must also maintain accurate recordings of stock

Question 4

What does the UK Companies Act require from all company financial statements?

Answer 4

A true and fair view. This means that the accounts must be:
Not misleading.
Accurate.
Reflecting reality.
Not bias.
Free from error.
Free from manipulation.

Question 5

What does the IASBs Conceptual Framework for Financial Reporting cover?

Answer 5

It covers:
The objective of financial reporting
The qualitative characteristics of financial reporting
Defines the elements of financial statements
Specifies the criteria used in measuring and recognising these elements
Identifies different measurement basis used to record transactions

Question 6

Who uses the framework?

Answer 6

The IASB themselves to write and update standards
Directors – to help prepare accounts where there is no specific standards
Auditors – to assist in judging how transactions are recorded
National standard setters like the ASB – writing and adapting national standards

Question 7

What are the objectives of Financial Reporting?

Answer 7

Stewardship – judging how well (or not so well!) the management of the company are doing at running the company.
Decision making – helping stakeholders make decisions about the company
E.g. helping a potential investor decide whether or not to buy shares in a company

Question 8

What does Going concern mean?

Answer 8

This means that a company will continue operating and trading for the foreseeable future. The standards are written under this assumption, that the company is a going concern.

Question 9

What are the main characteristics of financial statements?

Answer 9

Relevance
Materiality
Faithful representation

Question 10

What does Relevance mean?

Answer 10

This means that information must be capable of affecting a users’ decision.
Relevant information can be predictive (helps predict or forecast future events) or confirmatory (helps confirm or deny an expectation).

Question 11

What does Materiality mean?

Answer 11

Information which would impact on a users understanding of the financial statements or decisions made should not be omitted.

Question 12

What does Faithful representation mean?

Answer 12

Information should accurately represent the reality of what is going on (this might be different to the legal form).
For example, if a company acquires a property on a 999 year lease, legally it belongs to someone else (the company officially is just leasing it) but in reality the company owns and controls it. To faithfully represent information needs to have the three following characteristics
Complete:
All the information required to make a judgement should be included
Neutral:
The information should not be bias or have a “spin” put on it – we should also follow the prudence principle of ensuring that we do not forward recognise profits.
Free from error:
Information should be free from error or omission.
The framework is very clear that this does not mean that estimates cannot be used.
If we could not use estimates then accounting would be impossible, it does however mean that the process of arriving at these estimates should be (as far as possible) free from error and any limitations explained.

Question 13

What qualities does the framework recognise for improving the quality of the information provided?

Answer 13

Comparability:
Allows the information to be compared both with itself (over different time periods) and with other entities
Verifiability:
Verifiability is a characteristic which allows users to confirm or verify that the information in the accounts is correct.
Timeliness:
The information is available in time to influence decisions
Understandability:
The information understandable and presented clearly.

Question 14

A Plc has had the following transactions:
Purchased a vehicle on credit for £20,000. Payment is due within 30 days.
Last December a sale of £400 was made to Rightsure Ltd. Rightsure have not paid and have now gone into administration
Carolwitz Plc. Have been discussing an order of £30,000 with A Plc.
Should these be recognised?

Answer 14

The purchase of the vehicle should be recognized as a liability (accounts payable).
The sale to Rightsure Ltd. should be recognized as a bad debt expense.
The discussion with Carolwitz Plc. should not be recognized until the order is confirmed.

Question 15

What are the Bases of measurement under the framework?

Answer 15

4 bases are allowed under the framework:
Historic cost -
A building was purchased in 1994 for £45,000. It’s historic cost is £45,000.
Current cost - A piece of specialist machinery was acquired 4 years ago for £200,000. The cost of an equivalent piece of machinery today would be £280,000. The current cost is therefore £280,000.
Realisable (fair) value -
The building purchased (earlier example) for £45,000 is estimated to be worth £150,000 today by a surveyor. The realisable value is therefore £150,000
Often we use Net Realisable Value (NRV), the selling price less any necessary costs. For example if the selling the building would lead to estate agents fees of £3,000, then the NRV would be £150,000 - £3,000 = £147,000.
Present value (value in use) - A piece of machinery is estimated to generate cashflows of £1,500,000 over the next eight years. Discounting using an appropriate rate to take into account inflation means that would be equivalent to a lump sum of £983,000 today.

Question 16

What is Cash accounting?

Answer 16

Rather than accounting for transactions when they occur this simply recognises cash in/cash out. This is the basis of a cashflow and is also used by some very small organisations.

Question 17

What is Commitment accounting?

Answer 17

Used by some government bodies – recognises transactions when an entity is committed to them. For example a school recognising its commitment to provide places to 300 pupils at the start of the year.

Question 18

What is Fund accounting?

Answer 18

Used by bodies which are looking after funds for others, e.g. investment banks and some government bodies. Emphasis on accountability of transactions.

Question 19

What is Tax base?

Answer 19

Amounts recognised for calculating tax are often different to those recognised for financial reporting.

Question 20

What is Break up basis?

Answer 20

Used by entities that are not a going concern, the immediate sale value of assets (less liabilities). This is usually lower, for example a trading restaurant is usually worth considerably more than a vacant and empty restaurant premises.

Question 21

What are some limitations of financial reporting?

Answer 21

Results are mainly historic, looks back at a particular period/point in time not necessarily representative of current situation
Some things are difficult or impossible to represent in financial statements, for example an advertising agency relies on creativity to survive and thrive – how do you put creativity on a balance sheet?
Often how things are valued/held for accounting purposes can be different from “real” value
Lack of consideration of non-financial measures such as:
Political factors,
Social factors,
The general economic climate,
Fashion.

Question 22

What are the different types of Regulators are there and what issues might they have with financial reporting and its standards?

Answer 22

Individuals – “Financial reporting is too complex, it needs to be simplified”.
Larger investors – “There’s not enough detail in financial statements. We need much more detail and information to make judgements”.
General public – “Financial reporting standards allow big companies to get away with all sorts of ‘accounting tricks’ – they need to be made stricter.”
Companies – “Financial reporting standards put too big a burden on business. They need to be cut back and simplified”
Accountants – “Financial reporting standards need to more clearly reflect what’s going on”

Question 23

What is IFRS13 about?

Answer 23

Valuing items at fair value.,
“…the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

Question 24

What 3 techniques do we use to find the fair value?

Answer 24

Level 1: The quoted price in an active market for an identical item.
Example
Shares in HSBC are identical – if you hold 1,000 shares in HSBC you can look at the stock market price and see exactly how much your holding is worth.

Level 2: Inputs other than quoted prices on identical items which are directly observable; so usually:
The quoted price on a similar item.
The price on a non active market.
Example: Smith Plc. owns a warehouse in Glasgow. A surveyor is able to consider what similar buildings have sold for recently to determine a fair value of £1,250,000.

Level 3: Non-observable inputs, usually based on some sort of internal calculation by the entity.
Highedge Ltd. owns a nuclear testing facility, this asset is completely unique.
Highedge have estimated the value of the research this will generate and have used a discounted method to determine the fair value of this facility.

(In an exam, unless told otherwise if you are given a fair value in an exam question assume it has been calculated using the best method available.
For example if a level 1 method was available, a level 1 method was used.)