The ASB has been working for some time to produce a definitive set of principles for financial reporting. A first draft consisting of seven chapters was issued in 1995. A revised draft was produced in March 1999, and this was followed in December 1999 by the final version which is the subject of this article. The full text of the Statement is about 100 pages long, plus a further 40 pages of appendices. This article, and part 2 next month, attempts to present the material most relevant for the examinations.

This first article deals with Chapters 1 to 3.

For paper 1, only Chapters 1 and 3 are relevant. For papers 10 and 13, the whole of the Statement must be studied. Some more notes on the examinability of the Statement appear at the end of next month’s article.

Purpose of the Statement

The introduction to the Statement sets out the reasons for creating it.

The primary purpose is to provide a coherent frame of reference to be used by the ASB in the development and review of accounting standards and by others who interact with the ASB during the standard-setting process.

The Statement is being published because knowledge of the principles should assist preparers and users of financial statements, as well as auditors and others, to understand better the ASB’s approach to formulating standards and the nature and function of information reported in general purpose financial statements. It will also assist preparers and auditors in analysing new or emerging issues in the absence of applicable accounting standards.

It is important to bear in mind that the Statement is not an accounting standard nor does it have a status equivalent to an accounting standard. It therefore does not contain requirements on how financial statements should be prepared or presented.

The Statement consists of eight chapters:

1. The objective of financial statements.
2. The reporting entity.
3. The qualitative characteristics of financial information.
4. The elements of financial statements.
5. Recognition in financial statements.
6. Measurement in financial statements.
7. Presentation of financial information.
8. Accounting for interests in other entities

Chapter 1 — The objective of financial statements

The objective of financial statements is to provide information about the reporting entity’s financial performance and financial position that is useful to a wide range of users for assessing the stewardship of management and for making economic decisions.

The Statement then lists the users of financial statements and their information needs, recognising that investors are the main users and that information satisfying their needs will also be of use to the others.

The users considered in the Statement: are:

(a) Investors

Providers of risk capital are interested in information that helps them to assess the stewardship of management and in taking decisions about their investment or potential investment in the entity. They are, as a result, concerned with the risk inherent in, and return provided by, their investments, and need information on the entity’s financial performance and financial position that helps them to assess its cash-generation abilities and its financial adaptability.

(b) Lenders

(c) Suppliers and other trade creditors

(d) Employees

(e) Customers

(f) Governments and their agencies

(g) The public

The Statement also recognises that financial statements have limitations, and lists the following as examples of such limitations:

(a) They are a conventionalised representation of transactions and other events that involves a substantial degree of classification and aggregation and the allocation of the effects of continuous operations to discrete reporting periods.

(b) They focus on the financial effects of transactions and other events and do not focus to any significant extent on their non-financial effects or on non-financial information in general.

(c) They provide information that is largely historical, and therefore do not reflect future events or transactions that may enhance or impair the entity’s operations, nor do they anticipate the impact of changes in the economic or potential environment.

The information required by investors

The Statement identifies four areas in which investors require information:

(a) Financial performance

Information on financial performance is needed to provide:

1. an account of management’s stewardship;
2. means of assessing the entity’s capacity to generate cash flows and the effectiveness with which the entity has employed its resources;
3. feedback on previous assessments of financial performance.

Information about financial performance is provided by the profit and loss account, the statement of recognised gains and losses and the cash flow statement.

(b) Financial position

Information about financial position is needed to provide:

1. details of economic resources controlled by the entity and the use made of them;
2. details of financial structure;
3. details of an entity’s risk profile and risk management approach to evaluate its current performance, financial adaptability and ability to generate cash in the future;
4. a means to assess the entity’s capacity to adapt to changes in the environment — its financial adaptability.

Information about financial position is given in the balance sheet.

(c) Generation and use of cash

Investors need such information because it is useful in assessing and reviewing previous assessments of:

1. liquidity and solvency;
2. the relationship between profits and cash flows;
3. the implications that financial performance has for future cash flows; and
4. other aspects of financial adaptability.

Such information is mainly provided by the cash flow statement.

(d) Financial adaptability

An entity’s financial adaptability is its ability to take effective action to alter the amount and timing of its cash flows so that it can respond to unexpected needs or opportunities.

Financial adaptability comes from several sources, including the ability to:

1. raise new capital, perhaps by issuing debt securities, at short notice;
2. repay capital or debt at short notice;
3. obtain cash by selling assets without disrupting continuing operations; and
4. achieve a rapid improvement in the net cash inflows generated by operations.

Chapter 2 — The reporting entity

The purpose of this short chapter is to define which entities need to prepare financial statements. This is based on the principle that entities should only be required to prepare financial statements if there is a legitimate demand for the information those financial statements would provide.

Based on this principle, Chapter 2 asserts that a single company, being a cohesive economic unit, should prepare financial statements. It goes on to assert that group financial statements are also required because the resources of the subsidiaries are controlled by the parent so that the whole group forms a cohesive economic unit.

Criteria for control

An entity will have control of a second entity if it has the ability to direct that entity’s operating and financial policies with a view to gaining economic benefit from its activities.

Control may be evidenced in a variety of ways, the most frequent being share ownership and voting rights.

Control implies the ability to restrict others from directing the financial and operating policies of the controlled entity, though this aspect is unlikely to form the sole basis of control.

Chapter 3 — The qualitative characteristics of financial information

Chapter 3 identifies the qualities which financial information should have.

There are four main headings, each with several sub-headings. The diagram (Figure 1) on the next page, reproduced from the Statement, shows them all. The notes which follow explain each point.

Materiality is, therefore, a threshold quality that is demanded of all information given in the financial statements. Furthermore, when immaterial information is given in the financial statements, the resulting clutter can impair the understandability of the other information provided. In such circumstances, the immaterial information will need to be excluded.

The principal factors to be taken into account in assessing materiality are:

(a) The item’s size is judged in the context both of the financial statements as a whole and of the other information available to users that would affect their evaluation of the financial statements. This includes, for example, considering how the item affects the evaluation of trends and similar considerations.

(b) Consideration is given to the item’s nature in relation to:

1. the transactions or other events giving rise to it;
2. the legality, sensitivity, normality and potential consequences of the event or transaction;
3. the identity of the parties involved; and
4. the particular headings and disclosures that are affected.

If there are two or more similar items, the materiality of the items in aggregate as well as of the items individually needs to be considered.

(2) Relevance

Information is relevant if it has the ability to influence the economic decisions of users and is provided in time to influence those decisions.

Relevant information has predictive value or confirmatory value.

2a Predictive Value

Information has predictive value if it helps users to evaluate or assess past, present or future events.

2b Confirmatory Value

Information has confirmatory value if it helps users to confirm or correct their past evaluations and assessments.

Overall then, the criterion of relevance relates to economic decisions of users. It means that information disclosed in financial statements is only valuable if it helps users to make predictions about the future or if it confirms past evaluations.

For example, information about the current level and structure of asset holdings helps users to assess the entity’s ability to exploit opportunities and react to adverse situations. The same information helps to confirm past assessments about the structure of the entity and the outcome of operations.

(3) Reliability

Information is reliable if:

(a) it can be depended upon by users to represent faithfully what it either purports to represent or could reasonably be expected to represent;

(b) it is free from deliberate or systematic bias (i.e. it is neutral);

(c) it is free from material error;

(d) it is complete within the bounds of materiality; and

(e) in its preparation under conditions of uncertainty, a degree of caution (i.e. prudence) has been applied in exercising judgement and making the necessary estimates.

3a Faithful representation

The portrayal of a transaction or other event in the financial statements depends, inter alia, on:

(a) the rights and obligations arising and the weight attached to each;

(b) how the rights and obligations to which most weight has been attached are characterised;

(c) which measurement basis (or bases) and presentation techniques are used to depict the rights and obligations; and

(d) the way in which the elements arising from the transaction or other event are presented in the financial statements.

3b Neutrality

The information provided by financial statements needs to be neutral — in other words, free from deliberate or systematic bias. Financial information is not neutral if it has been selected or presented in such a way as to influence the making of a decision or judgement in order to achieve a predetermined result or outcome.

3c Freedom from material error

An unqualified external auditors’ report should be an assurance that the financial statements are free from material error. This in turn is based upon the effectiveness of the entity’s internal controls, including its internal audit department, if any.

3d Completeness

Information in financial statements must be complete, within the limits set by materiality and by the structure and format of financial statements.

Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that gains and assets are not overstated and losses and liabilities are not understated. In particular, under such conditions it requires more confirmatory evidence about the existence of, and a greater reliability of measurement for, assets and gains than is required for liabilities and losses.

However, it is not necessary to exercise prudence where there is no uncertainty. Nor is it appropriate to use prudence in order, for example, to create hidden reserves or excessive provisions, deliberately understating assets or gains, or deliberately overstating liabilities or losses, because that would mean that the financial statements are not neutral and, therefore, are not reliable.

(4) Comparability

Information in an entity’s financial statements gains greatly in usefulness if it can be compared with similar information about the entity for some other period or point in time in order to identify trends in financial performance and financial position. Information about an entity is also much more useful if it can be compared with similar information about other entities in order to evaluate their relative financial performance and financial position.

Information in financial statements therefore needs to be comparable — at least as far as is possible. Furthermore, to help users to make comparisons, such information needs to be prepared and presented in a way that enables users to discern and evaluate similarities in, and differences between, the nature and effects of transactions and other events taking place over time and across different reporting entities. This can usually be achieved through a combination of consistency and disclosure of accounting policies.

4a Consistency

Consistency is an important accounting concept but it cannot be applied in all circumstances. For example, the introduction of a new accounting standard may require changes. The point is that consistency of treatment and accounting policies will be maintained as far as possible, with full disclosure of the effect of necessary changes when they happen.

4b Disclosure

As suggested in 4(a), disclosure is important in achieving comparability.

Disclosures required in this context are:

the entity’s accounting policies and changes in them;

the effects of changes on the financial statements.

5 Understandability

It is no good having all the above points attended to if the financial statements are then presented in a way difficult for users to understand. Two sub-headings are considered:

• users’ abilities; and
• aggregation and classification.

5a Users’ abilities

Financial statements have to deal with complex matters in many areas. Those preparing financial statements are entitled to assume that users have a reasonable knowledge of business and economic activities and accounting and a willingness to study with reasonable diligence the information provided.

5b Aggregation and classification

The presentation of financial information should ensure that items are aggregated and classified appropriately. See Chapter 7 next month for more on presentation.

Limits on the application of the qualitative characteristics

Balance between characteristics

It is not always possible to reconcile conflicts between the characteristics of relevance, reliability, comparability and understandability, and a trade-off may be necessary. Some examples given in the Statement are conflicts involving:

(i) Relevance and reliability

Sometimes the information that is the most relevant is not the most reliable and vice versa. Choosing the amount at which to measure an asset or liability will sometimes involve just such a conflict. In such circumstances, it will usually be appropriate to use the information that is the most relevant of whichever information is reliable.

(ii) Timeliness

Conflict between relevance and reliability can also arise over the timeliness of information. That is because a delay in providing information can make it out-of-date, which will affect its relevance, yet reporting on transactions and other events before all the uncertainties involved are resolved may affect the information’s reliability. On the other hand, leaving information out of the financial statements because of reliability concerns may affect the completeness, and therefore reliability, of the information that is provided. Although financial information should generally be made available as soon as it is reliable and entities should do all that they reasonably can to speed up the process necessary to make information reliable, financial information should not be provided until it is reliable.

(iii) Neutrality and prudence

There can also be tension between two aspects of reliability — neutrality and prudence — because, whilst neutrality involves freedom from deliberate or systematic bias, prudence is a potentially biased concept that seeks to ensure that, under conditions of uncertainty, gains and assets are not overstated and losses and liabilities are not understated. This tension exists only where there is uncertainty, because it is only then that prudence needs to be exercised. When there is uncertainty, the competing demands of neutrality and prudence are reconciled by finding a balance that ensures that the deliberate and systematic understatement of gains and assets and overstatement of losses and liabilities do not occur.

(iv) Understandability

It may not always be possible to present a piece of relevant, reliable and comparable information in a way that can be understood by all the users with the capabilities described in 5(a) above. However, information that is relevant and reliable should not be excluded from the financial statements simply because it is too difficult for some users to understand.

Coverage of chapters 4 – 8 of the Statement will appear next month.