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Roberto Di Pietra1

� DEPARTMENT OF BUSINESS AND LAW

ROBERTO DI PIETRA

SIENA, NOVEMBER 4, 2013

International Financial

Accounting (IFA)

Part I – Accounting Regulation; Normative Theories of

Accounting

Roberto Di Pietra2

INTERNATIONAL FINANCIAL ACCOUNTING

Part I – Accounting Regulation� International Accounting

� Normative Theories of Accounting

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NORMATIVE THEORIES OF ACCOUNTING

• Users and their information needs (Before 2008)

� The Framework regards investors as the primary, overriding user group

• The Framework notes that FSs cannot provide all the information that users may need to make economic decisions

• FSs show the financial effects of past events and transactions, whereas the decisions that most users of FSs have to make relate to future

• The information in FSs helps users to make their own forecasts

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• Users and their information needs

� After IASB-FASB Convergence project (2008 ED)

� The primary user group includes both present and

potential equity investors, lenders and other

creditors, regardless of how they obtained, or will

obtain, their interests

� Users of financial reports are assumed to have a

reasonable knowledge of business and economic

activities and to be able to read a financial report

� In making decisions, users also should review and

analyse the information with reasonable diligence

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• Responsibility for FSs

�The management of an entity has the primary responsibility for preparing and presenting the entity’s FSs

• This responsibility is noted in the auditor’s

report in most countries

• Some countries require that company management include, as part of the FSs,

an explicit statement of management’s

responsibility for the FSs

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• Responsibility for FSs

�The auditor’s responsibility is to form and express an opinion as to whether the FSs are prepared in accordance with IFRS or some other identified financial-reporting framework

�The fact that FSs are audited does not relieve management of its fundamental responsibility

� In a converse case this could show a sort of conflict of interest that could affect the expression of an independent opinion

• ISA 700 on the Auditor’s Report on FSs requires that the auditor’s report include a statement that the FSs are the responsibility of the entity’s management

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• The Objective of FSs

�Is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions

�Decision usefulness is an objective of FSs (this has been subject of heated debate)

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�On the basis of the various normative theories of accounting the objective of the Financial reports could be referred to

• The Stewardship theory• Understand whether the resources entrusted to

management have been used for their intended or appropriate purposes; the historical cost accounting enables management to report effectively on the stewardship of resources

• The Decision usefulness approach• The main aim of financial reports is to support the

rational decisions of users

• The Accountability approach• The duty to provide an account or reckoning of those

actions for which one is held responsible

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�From one hand the objective as set out in the IASB Framework is to help people to make decision

�From the other hand large part of the decisions are future-oriented

• Some disagree with this objective

• They argue that the FSs is strictly to be a scorecard of the past (stewardship objective of FSs)

• The IASB Framework does not reject this objective, but it says that people want to know about the past (stewardship) not merely out of curiosity, but because they want to use the information about the past to help them in making future-oriented economic decisions

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Information from the past

Decision as a predictive process

Time series

Actualized Values

The Objective of Financial Statements

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� Financial position

• The financial position of an entity is

affected by economic resources under

• its “controls”,

• its “financial structure”,

• its “liquidity” and “solvency” and

• Its “capacity” to adapt to changes in the

environment in which it operates

• The “Balance sheet” presents this kind of information

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�Performance

• Performance is the ability of an entity to earn a profit

on the resources that have been invested in it

• Information about the “amount” and “variability” of

profits helps in forecasting future cash flows from the

entity’s existing resources and in forecasting

potential additional cash flows from additional

resources that might be invested in the entity

• Information about performance is primarily provided

in an “Income statement” (or “statement of profit

and loss”, or “statement of financial performance”)

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� Performance

• IAS 1 added a fourth basic financial statement:

The “statement showing the changes in equity”

• It is important to look to both the income

statement and the equity statement in assessing

performance because several IFRS provide that

certain items if income and expense should be

reported directly in equity (thereby by passing

the income statement) permanently or

temporarily

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� Performance

• Some examples• Changes in FV of available-for-sale financial assets are reported directly in

equity until financial asset is sold

• Major classes of property, plant and equipment are re-measured to FV at each BS, with the change in FV reported in a revaluation reserve directly in equity

• Foreign currency translation adjustment arising when the FSs of a foreign operation are translated from the foreign currency into the reporting company’s currency are reported directly in equity

• Companies have an option of reporting actuarial gains and losses on their pension funds directly in equity when they arise

• This value changes are part of an entity’s performance, but under existing IFRSs they are not reported in the IS; They show up in the Equity statement; In assessing performance, both of those FSs must be considered

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� Changes in financial position• Users of FSs seek information about the sources and

users of an entity’s cash and cash equivalents such as bank deposits during the reporting period

• Cash comes into and goes out of an entity from 3 broad categories of activity

• Its operations (producing and selling its goods and services)

• Its investing activities (buying and selling long-lived assets and financial investments)

• Its financing activities (raising and repaying debt and equity capital)

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� Changes in financial position

• The “Cash Flow Statement” (CFS)

provides this kind of information

• All investors, creditors, and other capital

providers to an entity want to get cash out

of their investment

• The cash flow statement helps them

assess the prospects of receiving cash from the entity

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� “Notes” and “Supplementary schedules”

� The FSs also contain “notes and supplementary schedules” and “other

information” that

• Explain items in the balance sheet and IS

• Explain any resources and obligations not

recognised in the BS

� The notes also sometimes contain information that meets disclosure requirements arising

under national laws or regulations

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• Going concern

• Accruals

• Matching

• Entity

• Materiality

• Time period

• Historical cost/Fair value

• Duality

• Prudence

• Substance over form

• Consistency

• Separate determination

• Recognition

• Measurement

Accounting Concepts

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• Going concern

� Is the assumption that an entity will continue in operational existence with the foreseeable future

� Any user when looking at en entity’s financial statements has the right to assume that the company is not going to liquidate or curtail materially the scale of its operations

• Accruals

� Is concerned with allocating expenses and income to the periods to which their relate

� The transactions should be recorded in the accounting records and reported in the financial statements in the period in which they relate

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• Matching

� Refers to the assumption that in the measurement

of profits, costs should be set against the revenue

that they generate at the time when this arises

• Entity

� This concept allows the user to look at a reporting

entity’s financial statements and to know that these

represent the performance and financial position of

the business unit and do not include assets,

liabilities, income and expenditure that are not

related to the business

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• Materiality

� Affects every transaction and every set of financial statements

� Affects two main areas:• Presentation (only material items should be disclosed

in FSs)

• Application of accounting standards (is when deciding whether to comply with guidance given in accounting standards)

• Time period

� Refers to the practice of dividing the life of an entity into discrete periods for the purpose of preparing FSs

• The norm is one year

• The period is different to one year, the FSs need to make it clear that this is the case

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• Historical cost

� Allows a user to assume that all the transactions in an entity’s FSs reflect the actual cost price billed, or revenue charged, for items

� Allows the reader to see the history of the management team’s investment decision-making from the statement of financial position

• Fair value

� The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction

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• Money measurement

� Allows the user to assume that the performance and financial position of a reporting entity will be expressed in monetary amounts

• Duality (dual aspect or double entry)

� Assumes that every transaction has two aspects (and due to this affects two accounts in a set of FSs in such a manner as to keep the accounting equation in balance)

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• Prudence

�Assumes that the FSs have been prepared on a prudent basis

�The user have to be confident that• no profits are included that are not earned and, if not yet

received, are reasonably certain to be received

• Expenses are complete and are not understated

• Assets are not overstated

• Liabilities are complete and not understated

• Substance over form

�Assumes that when accounting for transactions the preparer should look at the economic substance of a transaction, not its legal form

�This concept was introduced to try to stop the accounting practices that had emerged of creating complicated legal transactions which allowed transactions to be omitted from the FSs

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• Consistency

� Allows the user to look at a set of FSs over a number of years for an entity and to assume that the same methods, policies and estimation techniques have been used from year to year

• Separate determination

� An entity shall not offset assets and liabilities or income and expenses, unless required or permitted by an IFRS

� Company law does not allow netting, except in some limited instances

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• Recognition

� Is the process of including an item in either the Statement of Financial Position or in the Statement of Financial Performance

• Measurement

� Is the process of determining the monetary amounts at which the elements of the FSs are to be recognised and carried in the Statement of Financial Position and the Statement of Comprehensive Income

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• Underlying assumptions

�Going concern• The FSs presume that an entity will continue in

operation indefinitely• An entity that is not a going concern is likely to be

liquidated in the near term

• The users of the FSs of such an entity will have a great interest in the net amount of cash that can be generated from the entity’s assets in the very short term

• IFRS• are not necessarily designed to provide this kind of

information

• presume that entity will continue to operate for the foreseeable future and therefore will generate its cash flows from operations rather than from liquidation sales

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Qualitative characteristics

Fundamental

Enhancing

Relevance

Faithful representation

Materiality

Complete

Neutral

Free from errors Comparability

Verifiability

Understandability

Timeliness

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• Fundamental qualitative characteristics of FSs

� Relevance

• Information in FSs is relevant when it influences

the economic decisions of users

• It can do that by

• Helping users to evaluate past, present or

future events relating the entity

• Conforming or correcting past evaluations

users have made

• A sub-characteristic under the relevance is

Materiality

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�Relevance• Materiality: is a component of relevance

• Information is material if its omission or misstatement could influence the economic decisions of users

• Conversely if information does not have a bearing on the economic decisions of users, it is immaterial

• Neither the IASB Framework nor individual IFRS provide quantified measures of materiality (some traces are in IAS 14 and IAS 19)

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�Faithful representation

• To be faithful, information must represent

accurately the transaction or other circumstance

that the information purports to present

• To be a perfectly faithful representation, a

depiction would have 3 sub-characteristics:

• Completeness

• Neutrality

• Free from errors (Reliability)

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� Faithful representation• Completeness

• Faithful representation requires that the FSs must report what they purport to report completely, subject to constraints of cost and materiality

• Omissions make FSs just as wrong as unreliable or irrelevant information

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�Faithful representation• Neutrality

• The Framework is clear that accounting information must be decision-neutral

• This means that information is not designed in a way that intentionally leads the users of that information to make an economic decision that the preparer of the information would like them to make

• Saying that accounting information should be decision-neutral is entirely consistent with saying that accounting information should be relevant

• Relevance requires that the information bear on the economic decisions that users want to make

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�Faithful representation• Free from errors

• Information in FSs is faithful if it is free from material error and bias and can be dependent on by users to represent events and transactions faithfully

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• Enhancing qualitative characteristics of FSs

�Comparability, Verifiability, Timeliness and Understandability are qualitative characteristics that enhance the usefulness of information that is relevant and faithfully represented

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� Comparability

• User must be able to compare the FSs of an

entity over time so that they can identify trends

in its financial position and performance

• Users must also be able to compare the FSs to

different entities to make decisions about where

to invest their capital and at what price

• Disclosure of accounting policies is essential for

comparability

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�Verifiability

• Verifiability means that different knowledgeable

and independent observers could reach

consensus that a particular depiction is a faithful

representation

• Verification con be direct and indirect

• Direct verification means verifying an amount or

other representation through direct observation (i.e.

checking counting cash)

• Indirect verification means checking the inputs to a

model, formula or other technique and recalculating

the outputs using the same methodology

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� Timeliness

• To be useful, information must be provided to

users within the time period in which it is most

likely to bear on their decisions

• Generally, the older the information is the less

useful it is

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�Understandability

• Information should be presented in a way that is readily understandable by

users

• Who have a reasonable knowledge of

business economic activities and accounting

• Who are willing to study the information

diligently

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• The cost constraint on useful financial reporting

� Balance between benefit and cost

• The benefits that users of FSs derive from information should exceed the cost of providing that information

• The evaluation of benefits and costs is a difficult judgemental process (costs of providing information should include direct and indirect costs for its preparation)

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Preparation Presentation

Relevance

Faithfulrepresentation

ComparabilityVerifiability

Timeliness

Understandability

ConstraintsCost/Benefits

Balancing Qualitative characteristics of FSs

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• Can FSs provide neutral and unbiased accounts of an entity’s performance and position?

� Despite the attribute of Faithful representation there are many forces driving the financial accounting towards specific interests

� Positive accounting theory• There is a body of literature suggesting that those responsible

for preparing FSs will be driven by self-interest to select accounting methods that lead to favourable outcomes for their own personal wealth

• This literature predicts that managers involved in the accounting function will always put their self-interest ahead of the interests of others

� Accounting regulation as a political process• The process leading to finalize accounting standards can be

considered political

• The political solutions and compromises impact on the financial information being presented and that information is an outcome of a political process

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• Conceptual framework approaches to determine profit

�Asset/Liability approach

• Links the profit to changes that have occurred in the

assets and liabilities of the reporting entity

�Revenue/Expense approach

• Tends to rely on concepts such as the matching

principle, which is very much focused on actual

transactions and which gives limited consideration

to changes in the values of assets and liabilities

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• Conceptual framework approaches to determine profit

�Asset/Liability approach

• The principal consideration is determining how account for any transaction is to determine what impact this transaction has had on increasing/decreasing the values of assets and liabilities

• If so this impact is effectively treated as gain or loss

• The Statement of Financial Position (Balance Sheet) is the primary financial statement

�Revenue/Expense approach

• The Comprehensive Income Statement (Profit and Loss Account) is the primary financial statement

�The IASB Framework (and FASB) adopt the Asset/Liability approach

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• Conceptual Framework

� General purpose FS

� Objective

� Underlying assumption

� Fundamental and Enhancing qualitative

Characteristics

� Elements of the FS

• Definition

• Recognition

• Measurement

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• The Elements of FSs

�FSs “portray” the financial effects of transactions and other events by grouping them into broad classes according to their economic characteristics

• Elements directly related to financial position(BS):

• Assets

• Liabilities

• Equity

• Elements directly related to performance (IS):

• Income

• Expenses

• The CFS reflects both IS elements and changes in BS elements

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�Definitions of the elements relating to financial position

• Asset

• 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

• Liability

• 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

• Equity

• The residual interest in the assets of the entity after deducting all its liabilities

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�Assets, 3 key characteristics• There must be an expected future economic

benefit

• The reporting entity must control the resource that gives rise to these future economic benefits

• The transaction or other event giving rise to the reporting entity’s control over the future economic benefit must have occurred

�Liabilities, 3 key characteristics• There must be an expected future disposition or

transfer of economic benefit to other entities

• It must be a present obligation

• A past transaction or other event must have created the obligation

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�Definitions of the elements relating to

financial position

• “Economic benefits” means future flows of cash or

other assets

• An assets is expected to help generate cash or

other assets coming into the entity, and a liability

is expected to result in cash or other assets

flowing out of the entity

• Both the Asset and Liability definitions refer to

“past events”

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�Definitions of the elements relating to performance

• Income

• Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants

• Expense

• Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets, or the incurrence of liabilities that result in decreases in equity other than those relating to distributions to equity participants

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�Definitions of the elements relating to performance

• The definition of income encompasses both “revenue” and “gains”

• Revenue arises in the course of the normal operating activities of the entity

• Gains represent other items that meet the definition of income but that do not reflect from the normal sales of goods and services produced by the entities

• The definition of expenses encompasses “expenses” and “losses”

• Expenses arise in the course of the ordinary activities of an entity (cost of sales, wages, marketing costs, administrative costs, depreciation)

• Losses represent other items that meets the definition of expenses and may or may not arise in the course of the ordinary activities of the entity

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• Recognition of the elements of FSs

�Recognition is the process of incorporating in the BS an item that meets the definition of an element and satisfies both the following criteria for recognition

�An item that meets the definition of an element should be recognised if

• It is probable that any future economic benefit associated with the item will flow to or from the entity (probability)

• The item’s cost or value can be measured reliably (measurability)

• All items that satisfy these recognition criteria should be recognised in the BS or IS

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�The recognition criteria for the elements of FSs under the Framework are as follows:

• An asset is recognised in the BS when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably

• A liability is recognised in the BS when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably

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�The recognition criteria for the elements of FSs under the Framework are as follows:

• Income is recognised in the IS when an increase in future economic benefits related to an increase in an asset or a decrease in a liability has arisen that can be measured reliably

• Expenses are recognised when a decrease in future economic benefits related to a decrease in an asset or an increase in a liability has arisen that can be measured reliably

�Because equity is the arithmetic difference between assets and liabilities, a separate recognition criterion for equity is not needed

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�Recognition of revenue from the sale of goods• This revenue should be recognised when all of the

following criteria have been satisfied

• The seller has transferred to the buyer the significant risks and rewards of ownership

• The seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold

• The amount of revenue can be measured reliably

• It is probable that the economic benefits associated with the transaction will flow to the seller

• The costs incurred or to be incurred in respect of the transaction can be measured reliably

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�Recognition of revenue from the tendering of services

• This revenue should be recognised when all of the following criteria have been satisfied

• The amount of revenue can be measured reliably

• It is probable that the economic benefits will flow to the seller

• The stage of completion at the BS date can be measured reliably

• The costs incurred, or to be incurred, in respect of the transaction can be measured reliably

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�Recognition of revenue from interest,

royalties and dividends

• These revenues should be recognised when all

of the following criteria have been satisfied

• Interest should be recognised using the effective

interest method set out in IAS 39 (§ 5)

• Royalties should be recognised on an accrual

basis in accordance with the substance of the

relevant agreement

• Dividends should be recognised when the

shareholder’s right to receive payment is

established

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• Measurement of the elements of FSs

�Measurement involves assigning monetary

amounts at which the elements of the FSs are to be recognised and reported

• The Framework acknowledges that a variety of

measurement bases are used to “different

degrees” and in “varying combinations” in FSs

including:

• Historical cost

• Current replacement cost

• Net realisable value

• Present value (discounted expected future

cash flow)

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� Historical cost:

• Is the measurement basis most

commonly used today, but it is usually combined with other measurement

bases

� Net realisable value:

• Is an asset’s selling price or a liability’s

settlement amount

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�The Framework does not include concepts

or principles for selecting which measurement basis should be used for

particular elements of FSs or in particular

circumstances

• After covering the objective of FSs, qualitative

characteristics, and elements definitions, the

Framework addresses measurement in only three

paragraphs

• It is fair to say that this is a significant deficiency

in the Framework

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