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CHAPTER 1 THE CONCEPTUAL FRAMEWOK FOR FINANCIAL REPORTING CONCEPTUAL FRAMEWORK VS GAAP The framework is an attempt to institute a theoretical concept which shall provide a basis for the preparation of financial statements and provide a guide for standard setters in setting accounting standards. Before any conceptual framework, GAAP (generally accepted accounting practices) had been used by reporting entities for the preparation and presentation of financial statements. During this era, there were alternative methods for applying GAAPs of different countries which affected comparability of financial statements among entities in the same industry but in different countries. During the regime of GAAP, every country adopted a set of accounting statements using its local environment as the basis for choosing accounting policies. Hence, the argument of what constitute, a GAAP became a matter of debate even up to recent times. GAAP then refers to the general principles governing the practices of accounting and financial reporting. These principles or rules could be ascertained from: Stock Exchange Requirements of various countries, National Accounting Standards, Corporate law in various jurisdictions. In essence, the conceptual framework for financial reporting became a compendium of theories guiding accounting practices and the standard setting process. THE NEED FOR A CONCEPTUAL FRAMEWORK The under listed are some of the salient points that had driven the need for a conceptual framework for the presentation of financial statements: To reduce variation to alternative treatment of similar items by entities. To provide a guide for standard setters in different countries on the standard setting process. To provide a disciplined approach to the accounting standard setting processes. To reduce political pressure on standard setters in various legislations in the standard setting process this is possible as the responsible standard setters follow the framework and not the dictates of the pressure groups. The framework helped to eliminate the rigid rules adopted by the US FASB thereby entrenching principles which are better suited for financial reports to possess its qualitative characteristics. To narrow the different GAAPs around the world. To reduce ambiguities, inconsistencies and contradictions arising from the different interpretations of GAAPs,
2.1 ADVANTAGES OF THE CONCEPTUAL FRAMEWORK It provides a direction for standard setters to identify areas of accounting needing standard setting rather than dissipate energy and resources on areas that do not pose any real challenge. PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate) Page 1
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3.5 QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS. The framework highlighted four qualities of financial statement as follows: UNDERSTANDABILITY This quality connotes that Financial statements should be presented in a manner that its contents should be understood by a user having adequate knowledge reasonable to deduce facts from such Statements, preparers of financial statements are however admonished not to omit complex items while trying to achieve understandability. This is because if such complex items are not included, the financial statements may be incomplete. Thus, it is only those users who have technical knowledge that will be able to understand those users lacking such technical knowledge should consult experts to assist them in interpreting financial statements. 3.5.1 RELEVANCE PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate)
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4.1.1 DEFINITIONS ASSETS These are resources controlled by a firm as a result of past events which will lead to an inflow of resources embodying economic benefits and can be measured reliably. LIABILITIES These are obligations upon a firm as a result past events which settlement will lead to outflow of resources embodying economic benefits and can be measured reliability. EQUITY This is the residue interest in a firm which arises from the deduction of liabilities from assets. INCOME These are increases in assets or reduction in liabilities which arises to a reporting entity as a result of activities accruing in the normal course of business but not as a result of contribution of more equity. EXPENSES These are decreases in assets or increases in liabilities arising from activities in the normal course of business rather than contribution of equity. In essence, it could be seen that the whole items appending in a set of financial statements must belong to any of these five elements no matter its nature or size. If this is not so, then such items are not supposed to appear in a finance statement. The elements have those specifically recognized in SOFP and the SOCI. 5.0 RECOGNITION CRITERIA OF ELEMENTS OF FINANCIAL STATEMENTS Recognition refers to the instatement of an item on the face of financial statements. An item is recognized in the financial statement if such item is stated with a financial value in the financial statement. In order for an item (element) to be recognized, such item must possess these criteria: PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate) Page 6
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INTERNATIONAL FINANCIAL REPORTING INTERPRETATIONS COMMITTEE (IFRIC) PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate)
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REGULATION OF FINANCIAL REPORTING IN NGERIA PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate)
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IAS 20: ACCOUNTING FOR GOVERNMENT GRANTS AND GOVERNMENT ASSISTANCE. INTRODUCTION In several cases, businesses receive grants or subsidies or premiums from government as a way of the government trying to encourage investments or for any other reason by. IAS 20 covers the issues relating to accounting grants for monetary or non monetary nature to businesses. SCOPE OF IAS 20 The standard covers asset related grant or income related grants or government assistance to businesses except for; Grants relating to government assistance with respect to changes in prices (inflation or deflation). Grants relating to assets in respect of taxation covered by IAS 12 (Accounting for Taxes). Grants arising from business with government in the normal cause of operations. DEFINITION OF TERMS The under defined are some of the relevant terms as used in IAS 20: their understanding is important to digest the contents of the standard. GOVERNMENT: This refers to any public authority such as council, local govt., municipality, government agencies or any other authority having power to issue such grants as covered by IAS 20. PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate)
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IAS 40: INVESTMENT PROPERTIES INTRODUCTION Some businesses (reporting entities) own property or hold on lease properties which are not being used in the ordinary course of business nor intended for resale in the ordinary course of business but which are held for generating income in form of rental etc. Such property is regarded as Investment Property and the accounting treatment of such property is the focus of IAS 40. SCOPE OF IAS 40 The standard does not cover the following: Property held for resale in the ordinary course of business IAS 2. Property held for use in the ordinary course of business or for administrative purposes IAS 16 Property held on construction on behalf of a client in the ordinary course of business IAS 11, construction contracts. EXAMPLES OF INVESTMENT PROPERTY Land or building held for the generation of income to the entity or for capital appreciation. Property held on a finance lease which shall be put to use in conformity with the definition of investment property per IAS 40. CRITERIA FOR RECOGNITION AS INVESTMENT PROPERTY Before an asset (property) is classified as investment property, the following two conditions must be met: The property must be held in a manner as to probably generate an inflow of resources embodying economic benefits to the reporting entity The cost of the property must be capable of being measured reliably. INITIAL COST OF INVESTMENT PROPERTY Invoice cost plus transaction costs FV value of lease rentals or property cost whichever is lower. This is if the property is held under a finance lease SUBSEQUENT MEASUREMENT OF INVESTMENT PROPERTY IAS 40 recommends two methods for measurement investment property after initial recognition as: PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate)
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COST MODEL The cost model is as explained in IAS 16 in which the investment property is disclosed at historic cost and depreciated annually. However, by this method, the reporting entity must also disclose the FV of the investment property as a note to the accounts. TRANSFERS FROM IAS 40 TO IAS 16 AND VICE VERSA An item of investment property can also be transferred to be recognized as PPE if and only if there is a change in use. SCENARIO 1 If an owner occupied property held as PPE under IAS 16 is now being let out as an investment property, IAS 40 recommends that the asset should be recognized as IP using the FV of the property. However, a complication will arise where the carrying amount of the PPE (IAS 16) is different from its FV per IAS 40. The difference shall be written off against statement of changes in equity as a revaluation loss or gain. SCENARIO 2 An investment property carried at FV may be transferred to either PPE per 16 or inventories per IAS 2. The fair value of the IP should be used for recognition as IAS 16 or IAS 2. In this case, there will be no difference arising as the FV is the intrinsic value of the item. WHAT CONSTITUTES A FAIR VALUE The parties to the deal participated willingly hence it is not a forced sale. The buyer is motivated to buy by factors which were evaluated by him without compulsion. FV is determined using current market and economic factors unlike value in use which is determined using factors known only to the reporting entity. FV does not double count assets. For example, the cost of a building includes the cost of the land, physical structure and other fittings on the structure such as lifts, heaters, A/Cs etc. PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate)
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Is the property meant for resale in OCB? No Is the property owner occupied No Is the property being developed? No
YES
Inventory IAS 2
YES
until
an
IAS 16 with disclosure notes per IAS 40 PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate) FV Model IAS 40
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IAS 23: BORROWING COSTS INTRODUCTION Reporting entities sometimes take out locus or other forms of advances to acquire self constructed assets. The treatment of interest on such borrowings made with respect to funds for financing those self constructed assets is the focus of IAS 23. Before the revision of IAS 23, costs of borrowing for qualifying assets where hitherto expensed in the P&L in the period they are incurred. TERMINOLOGY BORROWING COSTS The cost of finance related to amounts borrowed to fund the construction (not acquisition) of qualifying assets. QUALIFYING ASSETS - These are those assets which are covered by the scope of IAS 23. EXAMPLES OF QUALIFYING ASSETS Inventory meant for resale but will take a substantial long time to construct or produce. Plant and machinery or other heavy duty equipment which the reporting entity is constructing for itself and in which the construction shall span over some accounting period. Property held as an investment per IAS 40 but which the reporting entity has borrowed funds to develop. NON QUALIFYING ASSETS The following does not qualify as per IAS23 Inventory held for resale but which does not take substantial time to produce. Assets acquired out rightly, having been completed by the vendor before being acquired with borrowed funds. EXPENSES QUALIFYING FOR CAPITALISATION IAS 23 recommends that all costs directly attributed to funds borrowed to finance a qualifying asset shall be capitalized by being added to the original amount borrowed less any income realized from the temporary re-investment of the part of the borrowed funds before they are used. Consequently, the following expenses qualify for capitalization; Interest paid on long term loans, overdrafts or other forms of advances taken for the development of qualifying assets Finance costs relating to finance leases paid on items qualifying under IAS 23. Premiums and other charges payable in respect of funds borrowed to finance qualifying assets. Any fund which would not have been taken out as borrowing had the qualifying asset not been undertaken is eligible for capitalization.
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ACCOUNTING STANDARDS RELATING TO THE MEASUREMENT OF FINANCIAL PERFORMANCE TOPIC OVERVIEW In the course of presentation of financial statements, certain errors, changes in estimates and misrepresentation of facts and figures may occur. When this happens, the reliability of the financial PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate) Page 27
WHEN A CHANGE IN ACCOUNTING POLICY IS PERMITTED The standard discourages a change in accounting policy as it states that any accounting policy chosen by a reporting entity should be applied consistently. However a change may be permitted under the following circumstances: When the law in force requires such a change When a new accounting standard requires such a change, and When the change will lead to the presentation of a more reliable financial report. PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate) Page 28
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Retained earnings at 1st January, 2007 were $14m. The cost of goods sold in 2008 includes the stock of $4.5m error in opening inventory. The income tax rate for both years was 25%. No dividends were paid in both years. Required: Show the income statement for 2008 with comparative figures and retained earnings. EXAMPLE 2 Using the following information, prepare the statement of changes in equity of Organza PLC for the year ended December 31, 2012: Organza PLC Statement of Comprehensive Income (extract) $000 PBIT 792 PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate) Page 30
$ Original Cost 120,000 Revaluation Surplus 40,000 Value at 1/1/2012 160,000 The properties had a revaluation on 31st December, 2012 of $110,000. Organza Plc previously accounted for its investment properties by crediting gains to a revaluation surplus as allowed by local GAAP. Organza plc now wishes to apply the fair value model of IAS 40 which states that gains and losses should be treated as changes in accounting policy in accordance with IAS 8. No adjustment has been made for the change in accounting policy or subsequent fall in value. Share capital: During the year the company had the following changes to its capital structure: An issue of $200,000 $1 ordinary bonus share capitalizing its share premium reserve An issue of $400,000 $1 ordinary shares at $1.40 per share. Equity: $ PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate) Page 31
Dividends: Dividends of $200,000 were paid during the year as agreed at the companys AGM.
IFRS 5: NON CURRENT ASSETS HELD FOR SALE AND DISCONTINUED OPERATIONS
INTRODUCTION This is a financial reporting standard which attempts to give users of financial statements an insight into the classification of assets in terms of management decision regarding whether such assets will continue to be the entitys asset in the nearest future or otherwise (fixed assets held for sale/disposal group) and also the classification of financial performance with respect of how permanent an entitys operational divisions will be in the nearest future (discontinued operations). It is a replacement for IAS 35; Discontinued Operations as fallout out of a joint project between the IASB UK and FASB US. Our discussion shall be focused on the issue of Assets Held for Sale separately and Discontinued Operations separately. IFRS 5 is superior to IAS 35 because it is more encompassing in scope having treated both held for sale assets and discontinued operations. SCOPE OF IFRS 5 The standard does not cover accounting issues arising from other assets treated in other standards such: Employee Benefits Scheme (IAS 19) Deferred Tax Assets (IAS 12) Assets held on construction contracts (IAS 11) PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate)
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DISCONTINUED OPERATIONS A discontinued operation is an operational segment of a reporting entity which has an identifiable cash flows and profitability separate from other components of the entity. Thus a discontinued operation can be a segment of an entity operating in a major line of business different from the other components of the reporting entity or a subsidiary of a group which is acquired primarily for sale within twelve months. A discontinued operation can be identified through its operations being separate from the rest of the other components of the entity or have a separate geographical location. The disclosure of discontinued operations enables the users of financial statements to be abreast of effects of a discontinued operation on the financial performance of a reporting entity. PRESENTATION OF DISCONTINUED OPERATIONS IN FINANCIAL STATEMENTS PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate) Page 34
$000 xxxxx (xxx) xxx (xx) (xx) xxx (xx) xxx (xx) xxx xxx xxxx
DISCLOSURE REQUIREMENTS IFRS 5 requires the following disclosure with respect to discontinued operations in the notes to the accounts: The asset classified as held for sale or disposed The result gains or losses from the classification of an asset as held for sale or discontinued operations, The facts and circumstances leading to the classification of an asset as held for sale. PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate) Page 35
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Sales Proceeds Cost to Sale: Refurbishment Costs Legal fees Other statutory fees NET PROCEEDS
(xx) xxx
VALUE IN USE The value in use of an asset is the sum of the discounted net cash flows arising from the future use of an assets including its residual value using the companys cost of capital in determining the value in sue of an asset, the following variables are relevant: - The predicted future cash inflows, - The predicted future cash outflows - The net inflows - The required rate of return (cost of capital), - The residual value of the assets (if any). Thus it can be said that the value in use of an asset is the intrinsic value of such asset. However much judgment is involved in determining value in use, thus VIU suffers from all the shortcomings of the NPV method of investment appraisal. VALUE IN USE- EXAMPLE Amoco Plc has machinery which manufactures a component whose unit selling price is $5. The annual production and sales of this product is 50,000,000 units. The associated cost of operating the machine is $18m per annum. This machine has an estimated useful life of 5 yrs from the date of purchase after which it will be disposed for $0.8m. Required: Calculate the value in use of this machine if the companys cost of capital is 10%. Assuming that the current market value of this machine is $27m and that legal expenses associated with the disposal is $0.5m, calculate the recoverable amount of the machine. CASH GENERATING UNITS There are situations when it is impracticable to identify cash flows attributable to an individual assets separately from other assets in the entity. In this situation, the cash flows attributable to the CGU should be used. A CGU is an identifiable group of assets treated as a single unit. A CGU is comparab;e to an operating segment per IFRS 8. PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate) Page 38
TESTING QUESTION On 1st January, 2012, Multiply Plc acquires Steamdays, a company that operates a railway from Lagos to Maiduguri. The summarized SOFP at FV of Steamdays on 1 st January, 2012 reflecting the terms of the acquisition is as follows: PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate) Page 40
The values of property and rail tracks and coaches are based on their value in use. The engines are valued at their net selling prices. On 1st February, 2012, Boko Haram the insurgents in Northern Nigeria targeted and bombed one of the steam engines and it damaged beyond repair. As a result of the damage of one of the steam engines, the passenger capacity of the company reduced and the value in use of the whole business after the incident was determined at $2m. As a result of fear of a repeated attack on the facilities of Multiply Plc, passenger capacities continued to reduce sporadically. In the light of this, the value in use of the whole business was further reduced to $1.8m on 31st March, 2013. On this date Multiply Plc received an offer of $900,000 for the operating license (it is transferable). The realizable value of the other net assets has not changed significantly. Require: Calculate the carrying amount of assets of Steamdays in Multiplys SOFP at 1 st February, 2012 and 31st March 2012 after recognizing the impairment losses.
IAS 37: PROVISIONS, CONTIGENT LIABILITIES AND CONTIGENT ASSETS INTRODUCTION PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate)
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OBLIGATION The reporting entity must be obliged either by law or by its own undertaking to settle a liability before a provision could be created. PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate) Page 42
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FINANCIAL INSTRUMENTS OVERVIEW Financial instruments are covered by three international accounting standards namely: 1. IAS 32- which deals with the accounting issues relating to the presentation of financial instruments including the treatment of compound instruments in terms of valuation and split into long term liabilities and equity considering its substance over form. 2. IAS 39 deals with recognition and measurement of financial instruments considering the nature of classification of financial instruments, not also forgetting the topic of hedging using derivatives. 3. IFRS 7 discusses the disclosure requirements with respect to financial instruments. It is an international accounting standard which replaced parts of the revised IAS 32. THE IMPORTANCE OF FINANCIAL INSTRUMENTS The need for an accounting standard dealing on financial instruments can be attributed to the following factors: 1. The growth of international trade has led to a rapid increase to the use of financial instruments in settling indebtedness and sourcing for funds for business financing. PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate)
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IAS 32: FINANCIAL INSTRUMENTS - PRESENTATION IAS 32 discusses the issues relating to the presentation of financial statements with respect to classification between financial assets and financial liabilities. It also handles the valuation of convertible debts focusing on the split of convertible debts into long term liability and equity according to the substance of the instrument and not on its legal form. SCOPE OF IAS 32 The standard does not cover issues treated in other standards such as subsidiaries, associates and joint ventures. EXAMPLES OF FINANCIAL ASSETS 1. Cash, 2. Receivables, 3. Equity instrument of other entities, and 4. Options EXAMPLES OF FINANCIAL LIABILITIES 1. Payables, 2. Bonds and debentures, 3. Redeemable preference shares. PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate) Page 49
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INITIAL MEASUREMENT OF FINANCIAL INSTRUMENTS Financial instruments shall be measured at cost on initial recognition. The cost of a financial instrument is the acquiring costs plus the transactions costs i.e. directly attributed costs of issue. However, fair values can be used for the recognition of traded instruments except for instruments designated at fair value through profit or loss whereby the issue costs are written off to P & L immediately they are incurred. The FV can be determined using DCF techniques unless there is a realistic market value for the instrument. SUBSEQUENT MEASUREMENTS OF FINANCIAL ASSETS After initial recognition, subsequent measurements depend on the classification of the instrument. The following are possible classification of financial assets and the methods of subsequent measurements: 1. FAIR VALUE THROUGH PROFIT OR LOSS This method assumes the fair value of the instrument without adjustment for costs of disposal. In this case, the instrument is revalued annually in group and adjustments in carrying amount written off to P & L. This is the method recommended by IAS 39; however it is not to be used when other classification had been used for initial recognition. This classification is appropriate for assets held for trading as PREPARED BY: EMEZI FRANCIS OBISIKE, AAT, ACA, ACCA (affiliate) Page 51
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