This is the second part of a two-part article on the ASB’s new statement of principles for Financial Reporting (the Statement). The first part dealt with chapters 1 to 3 of the Statement, and we now look at chapters 4 to 8 to complete the coverage.

Chapter 4 — The elements of financial statements

Chapter 4 identifies the seven elements of financial statements as:

Elements

Appear in

1 Assets	Balance Sheet
2 Liabilities	Balance Sheet
3 Ownership interest	Balance Sheet
4 Gains	Profit and loss account or statement of recognised gains and losses
5 Losses	Profit and loss account or statement of recognised gains and losses
6 Contributions from owners	Balance sheet
7 Distributions to owners	Profit and loss account if revenue, balance sheet if capital

Definitions

1 Assets
Assets are rights and other access to future economic benefits controlled by an entity as a result of past transactions or events. It is important to understand this definition properly. Note first of all that ownership is not required, so leased items can qualify as assets — control is the vital point in the definition. Secondly, there is reference to future economic benefits — if an item does not generate future economic benefits it is not an asset, or at any rate it has no value. Thirdly, the asset must have arisen‘as a result of past transactions or events’.

If the reporting entity’s control of the rights or other access to the future economic benefits involved is to represent an asset, it needs to be the result of past transactions or events. A reporting entity that has access to future economic benefits but did not, until after the balance sheet date, have the ability to restrict the access of others to those benefits, did not have an asset at the balance sheet date.

2 Liabilities
Liabilities are obligations of an entity to transfer economic benefits as a result of past transactions or events.

For there to be a liability there must be an obligation that might result in the transfer of economic benefits.

As with the definition of assets, it is necessary to understand each part of the definition. An obligation may arise because of a legal contract or because of commercial considerations which may impose a practical obligation even where no legal constraint exists.

Turning to the reference to transfers of economic benefits, it is interesting that the Statement says that for there to be a liability there must be an obligation that might result in the transfer of economic benefits. The inclusion of that 'might' means that provisions and even contingent liabilities qualify as liabilities even though they may not be recognised in financial statements.

The liability must arise from past transactions or events. For example, an obligation to repair goods sold subject to warranty cannot be avoided once the goods have been sold, so the sale marks the inception of the liability.

One unusual feature of the Statement’s position on liabilities is that proposed dividends would not be recognised as liabilities. This is in line with practice in the USA and with the requirements of International Accounting Standards, but differs from long-established UK practice of including proposed dividends in the balance sheet. The Companies Act 1985 requires them to be shown as such.

Offsetting rights and obligations
If a right to receive future economic benefits and an obligation to transfer future economic benefits exist and the reporting entity has the ability — which is assured — to insist on net settlement of the balances, the right and obligation together form a single asset or liability regardless of how the parties intend to settle the balances.

In all other circumstances, the right and obligation — asset and liability — must be shown separately.

3 Ownership interest
Ownership interest is defined as follows:

Ownership interest is the residual amount found by deducting all of the entity’s liabilities from all of the entity’s assets.

4 and 5 Gains and losses
Financial statements draw a distinction between changes in ownership interest arising from transactions with owners in their capacity as owners and other changes. These latter changes are gains and losses and are defined as follows:

Gains are increases in ownership interest not resulting from contributions from owners.

Losses are decreases in ownership interest not resulting from distributions to owners.

The terms ‘gains’ and ‘losses’ therefore include items that are often referred to as ‘revenue’ and ‘expenses’, as well as gains and losses arising from, for example, the disposal of fixed assets and the remeasurement of assets and liabilities.

Offsetting gains and losses
Some transactions give rise to a gain (or a loss) that is the net of two amounts: the revenue or income arising from the transaction and the expenses or costs incurred in generating that revenue. For example, the profit that arises on selling an item of stock is the difference between the sale proceeds and the cost of the item sold. For the purpose of the Statement, the sale proceeds and cost of the item sold are separate items — the former being a gain and the latter a loss. Whether such gains and losses are shown separately in the financial statements is a presentation issue and is considered in Chapter 7.

6 Contributions from owners
Contributions from owners are increases in ownership interest resulting from transfers from owners in their capacity as owners.

Such transfers will normally be capital items, such as the purchase by owners of additional equity shares.

7 Distributions to owners
Distributions to owners are decreases in ownership interest resulting from transfers to owners in their capacity as owners.

Distributions to owners include the payment of dividends and the return of capital. A purchase by a company of its own shares is an example of a return of capital and is therefore reflected in financial statements by reducing the amount of ownership interest.

Chapter 5 Recognition in Financial Statements

Chapter 5 considers the conditions which must exist before a transaction or event is recognised in the financial statements.

The principles to be applied are:

(a) If a transaction or other event has created a new asset or liability or added to an existing asset or liability, that effect will be recognised if:

(i) sufficient evidence exists that the new asset or liability has been created or that there has been an addition to an existing asset or liability; and

(ii) the new asset or liability or the addition to the existing asset or liability can be measured at a monetary amount with sufficient reliability.

(b) In a transaction involving the provision of services or goods for a net gain, the recognition criteria described above will be met on the occurrence of the critical event in the operating cycle involved.

The identity of the critical event will depend on circumstances. The critical event normally occurs at the moment when the reporting entity has carried out all its obligations under an agreement except for a few minor details. An obvious example is the recognition of revenue from the sale of goods when the significant risks and rewards of ownership of the goods are transferred and the amount of revenue can be measured reliably.

Chapter 5 also considers the circumstances in which an asset should be ‘derecognised’. The principle to be applied here is that an asset or liability will be wholly or partly derecognised if:

(i) sufficient evidence exists that a transaction or other past event has eliminated all or part of a previously recognised asset or liability; or

(ii) although the item continues to be an asset or a liability, the criteria for recognition are no longer met.

The recognition process

The recognition process has the following stages:

(a) initial recognition, which is where an item is depicted in the primary financial statements for the first time;

(b) subsequent remeasurement, which involves changing the amount at which an already recognised asset or liability is stated in the primary financial statements; and

(c) derecognition, which is where an item that was until then recognised ceases to be recognised.

Uncertainty and the recognition process
Most events and transactions will be recognised as soon as they arise. For some, however, there will be uncertainty. The Statement suggests that it is unrealistic to delay recognition until there is complete certainty, and that an event or transaction should be recognised when the uncertainty has been reduced to an acceptable level. (The differing treatments of contingencies in FRS 12 Provisions, Contingent Liabilities and Contingent Assets, provide an illustration of the operation of this principle).

Derecognition
In routine events or transactions, the time for derecognition is easily identified. For example, cash may be spent, or debtors collected, resulting in derecognition.

It may sometimes be difficult to decide precisely when derecognition should occur. In those cases, the principle stated in the previous paragraph relating to uncertainty and the recognition process should be followed — derecognise when the required level of certainty is reached.

Revenue recognition
The principles governing revenue recognition in the Statement are much the same as those established for the recognition of transactions or events.

The Statement goes on to deal with matching and identifies two forms:

(a) Time matching involves the recognition of receipts (and payments) directly associated with the passage of time as gains (and losses) on a systematic basis over the course of the period involved. For example, rent paid at the beginning of a rental period, with amounts paid in advance of such recognition being recognised as an asset.

(b) Revenue/expenditure matching involves the recognition of expenditure directly associated with the generation of specific gains as a loss in the same period as the gains are recognised, rather than in the period in which the expenditure is incurred. For example, the cost incurred in obtaining or producing an item of stock is recognised in the performance statement as a loss in the same reporting period as the gain on selling that item, and in the meantime is recognised as an asset.

Almost all expenditure is undertaken with a view to acquiring some form of benefit in exchange. Consequently, if matching were used in an unrestricted way, it would be possible to delay the recognition in the performance statement of most items of expenditure insofar as the hoped-for benefits still lay in the future. The Statement imposes a degree of discipline on this process because only items that meet the definitions of, and relevant recognition criteria for, assets, liabilities or ownership interest are recognised in the balance sheet.

This means that the Statement does not use the notion of matching as the main driver of the recognition process. Nevertheless, the Statement envisages that:

(a) if the future economic benefits embodied in the asset are eliminated at a single point in time, it is at that point that the asset will be derecognised and a loss recognised; and

(b) if the future economic benefits are eliminated over several accounting periods — typically because they are being consumed over a period of time — the cost of the asset that comprises the future economic benefits will be recognised as a loss in the performance statement over those accounting periods.

Chapter 6 Measurement in Financial Statements

The Statement envisages the use of a mixed measurement system in which some items will be measured at historical cost and others at current value. This is the system normally used in the UK, at least by larger companies, with some fixed assets being revalued on a regular basis.

The choice of measurement basis for any particular category of assets or liabilities should consider the following factors:

1 Although the nature of the evidence will vary from item to item, its primary source will be past or present experience with the item itself or with similar items. This will include evidence provided by:

(a) current information directly relating to the item (e.g., the current physical condition of items of stock, their current selling price, and current levels of orders for them).

(b) other entities’ transactions in similar assets and liabilities. If such transactions are frequent and the items traded are very similar to the item held by the reporting entity (i.e., there is an efficient market in homogeneous items), such evidence will often be sufficient. However, as the frequency of transactions decreases or differences between the items traded and the item held by the reporting entity increase, the evidence will become less persuasive and is less likely to be sufficient on its own.

(c) past experience with a group of similar items (e.g., the levels of losses arising in the past on stock of different ages).

2 The issues to be considered in deciding whether the new amount of the asset or liability is capable of being measured with sufficient reliability are identical to the reliability of measurement issues considered in the context of initial recognition.

3 In choosing the measurement basis to be used for a particular category of assets or liabilities, the aim is to select the basis that is most appropriate bearing in mind:

(a) the objective of financial statements and the qualitative characteristics of financial information, in particular relevance and reliability;

(b) the nature of the assets or liabilities concerned; and

(c) the particular circumstances involved.

The initial measurement of an asset or liability is normally cost, whether the historical cost basis or the current value basis is applied to it. Subsequent remeasurement will then depend on the measurement method in use:

(a) Remeasurement under historical cost accounting
Under historical cost accounting the carrying value will be reduced by depreciation in the case of most fixed assets and by the need to adjust value downwards for both fixed and current assets to reflect the recoverable amount.

(b) Remeasurement under current value basis
The reductions mentioned in (a) above will also apply to assets to which the current value basis applies, but in addition, items will be periodically revalued to ensure that they are measured at an up-to-date current value. (These revaluations will only take place if they can be carried out with reliability, of course). It is not acceptable to revalue an asset and then retain it at the same amount for a long period of time. Once revaluation is adopted as the policy, values must be kept up-to-date.

In determining the appropriate current value, it is usual to take the value to the business determined as shown in the following diagram:

Capital maintenance adjustments and changing prices

The Statement defines the capital of an entity as the monetary amount of ownership interest (the financial capital maintenance concept). The Statement recognises that this approach is open to criticism when there are substantial general or specific price changes, and suggests the following procedures:

(a) General price changes
General price changes can affect the significance of reported profits and of ownership interest. If this problem is acute, an approach will need to be adopted that involves recognising profit only after adjustments have been made to maintain the purchasing power of the entity’s financial capital.

(b) Specific price changes
Specific price changes can affect the significance of reported profits and financial position. If the problem is acute, it will be necessary to adopt a system of accounting that informs the user of the significance of specific price changes for the entity’s financial performance and financial position.

Chapter 7 Presentation of Financial Information

Chapter 7 discusses the principles of good presentation. It first identifies the components of financial statements:

• statements of financial performance — profit and loss account and statement of recognised gains and losses;
• balance sheet;
• cash flow statement;
• supporting notes.

Financial statements are usually accompanied by other information such as the chairman’s statement or five-year trend tables. Chapter 7 briefly refers to these also, under the heading ‘accompanying information’.

Principles of presentation

(a) The objective of the presentation adopted is to communicate clearly and effectively and in as simple a manner as possible (really a repetition of the ‘understandability’ characteristic from Chapter 3)

(b) The presentation of information in financial statements must involve a fair degree of interpretation, simplification, abstraction and aggregation. Nevertheless, if this process is carried out in an orderly manner, greater knowledge will result because such a presentation will:

1. Convey information that would otherwise have been obscured;
2. Highlight those items, and relationships between items, that are generally of most significance.
3. Facilitate comparability between different entities’ financial statements; and
4. Be more understandable to users.

(c) The notes and primary financial statements form an integrated whole, with the notes amplifying and explaining the statements by, for example, providing:

1. (i) More detailed information on items recognised in the primary financial statements. Good presentation strikes a balance between the detail provided on the face of the primary financial statements and that provided in the notes, thus avoiding cluttering up the former and obscuring their message.

2. Context for, or an alternative view of, items recognised in the primary financial statements. For instance, if a balance sheet includes a liability that is in dispute, the related note might disclose the range of possible outcomes. Simllarly, the notes usually provide segmental information to supplement the primary financial statements, which focus on the reporting entity in aggregate.

3. Relevant information that it is not practicable to incorporate in the primary financial statements, for example because of pervasive uncertainty.

Chapter 8 Accounting for Interests in Other Entities

Chapter 8 of the Statement does little more than state the normal practice as regards the preparation of consolidated financial statements.

Levels of interest

The Statement recognises four levels of interest an entity may have in other entities:

• Controlling interest — the parent-subsidiary relationship;
• Joint control — the joint venture;
• Significant influence without control — the associated company relationship;
• Lesser or no interest — the simple investment.

(a) Controlling interest
In the investing entity’s own financial statements, investments giving a controlling interest will be accounted for like any other asset at cost or valuation.

In the group financial statements assets, liabilities, gains, losses and cash flows of all entities in the group are aggregated, even if the subsidiaries are not wholly owned. When subsidiaries are not wholly owned, the outside equity interest (the minority interest) is separately identified in the financial statements.

In the course of preparing the consolidated financial statements, a ‘goodwill’ balance may arise. Purchased goodwill (sometimes referred to as goodwill arising on acquisition) is the part of a parent’s investment in its subsidiary that has not been attributed to the separately identified assets and liabilities of the subsidiary. Although it is not an asset in itself, it is part of a larger asset (the investment). Furthermore, it does not represent a decrease in that larger asset’s value and therefore a loss: it represents part of the asset’s value. Therefore, if the parent’s investment is to be fully reflected in the group’s financial statements and the parent is to be held accountable for its investment in full, purchased goodwill needs to be recognised as if it were an asset.

(b) Joint control or significant influence without control
If the reporting entity shares joint control of, or exercises significant influence over, another entity, it will be directly involved in and affected by that other entity’s activities. Its interest in its investee is therefore reflected in the consolidated financial statements in a way that:

1. Recognises the reporting entity’s share of the results and net assets of the investee; and
2. Does not misrepresent the extent of its influence over the investee — in other words, it does not treat activities and resources that are not controlled by the reporting entity as if they are controlled by the reporting entity. At present, the only commonly recognised method of accounting for investments that achieves this end is the equity method of accounting. This is where the reporting entity’s share of the results and net assets of the investee are brought into its financial statements on a single line in the performance statement and balance sheet respectively. There are different types of equity method, usually involving the presentation of a greater or lesser degree of information than that just described, but in each case the reporting entity’s share of the net results and of the position of the investee are not combined in the primary financial statements on a line-by-line basis with the reporting entity’s own activities and resources.

(c) Investments involving lesser or no influence
The only amounts recognised in the consolidated financial statements will be the investment (if any) and any income derived therefrom.

Accounting for business combinations

The Statement briefly defines the two main ways in which entities may combine — by acquisition, when one entity purchases the whole or a controlling interest in another, and by merger, when two or more entities come together to form a new entity.

(a) Acquisition accounting
An acquisition is reflected in the consolidated financial statements by treating the assets and liabilities of the entity acquired and the purchased goodwill as if the transaction was the purchase of a bundle of assets and liabilities on the open market.

(b) Merger accounting (uniting of interests)
A merger is reflected in the financial statements of the new reporting entity comprising all the parties to the transaction as if that entity had always existed. As a result, the assets and liabilities of each party to the transaction are treated as if they were acquired by the new reporting entity at the time that they were acquired by the party concerned: none of the assets or liabilities is treated as being purchased at the time of the business combination as part of a bundle of assets and liabilities on the open market.

Conclusion — The Statement and the Examinations

The chapters in the Statement vary greatly in their examinability.

Paper 1 Accounting Framework
At this level only Chapters 1 and 3 are examinable. Both chapters can feature fairly frequently in the examination.

Some questions that could appear are:

• The objective of financial statements and the users of financial statements (Chapter 1);
• A selection from the characteristics of financial information to be defined and explained (Chapter 3).

Paper 10 Accounting and Audit Practice
The examination notes published in the Students’ Newsletter state that ‘students are expected to be aware of the issues/reasons which have led to the publication of the Statement of Principles, and to be able to discuss the main thrust of these documents’.

Questions at this level are likely to require integration of your knowledge of the Statement with FRSs, because some of the important issues dealt with in the Statement are also covered in FRSs. For example, FRS 15, Tangible Fixed Assets, deals with measurement of fixed assets, which is also covered in Chapter 6 of the Statement. A question on this topic could thus require reference to both the FRS and the Statement.

Paper 13 Financial Reporting Environment
The December 1999 examination notes for paper 13 do not refer specifically to the Statement. The position for paper 13 may be taken to be broadly as explained above for paper 10.