Chapter 3 – The Regulatory & Conceptual Framework

#Introduction to the Regulatory Framework

The financial statements display relevant information to internal and external users. The information displayed will influence decisions that stakeholders may make about the future of a particular business.

Regulations are set in place for businesses to prepare their financial statements according to standardised principles and rules so that users of financial statements can rely on the financial information as fairly represented.

The issuance of International Financial Reporting Standards (IFRS) and guidance comes from the International Accounting Standards Board (IASB), which the IFRS Foundation governs.

The governance structure of setting standards can be summarised in the diagram from the IFRS website below.

The formation of accounting standards can be represented in a three-tier structure:

• Independent Standard-Setting and Related Activity

There are two independent standard-setting boards of experts:

• International Accounting Standards Board(IASB), whose role is to develop and publish accounting standards. The Interpretations Committee works closely with IASB to support the application of the standards.
• International Sustainability Standards Board(ISSB), whose role is to develop a baseline of sustainability-related disclosure standards.

• Governance, Strategy and Oversight

The development of standards by IASB and ISSB is governed and overseen by Trustees (IFRS Foundation Trustees). The IFRS Advisory Council provides advice and counsel to the Trustees and the boards

• Public Accountability

The Trustees are accountable to a monitoring board of public authorities (IFRS Foundation Monitoring Board).

These regulatory bodies do not have the power to force companies to comply with their requirements. It is up to national accounting standard-setting bodies or regulators to adopt the standards, and only then will they become enforceable in a country.

National bodies can do this in different ways, including:

• adopting IFRS Accounting Standards as standards for their own country
• using IFRS Accounting Standards as a basis for developing their guidance
• developing their requirements but comparing them to IFRS Accounting Standards to determine if their standards are sufficient.

# IFRS Foundation – Trustees

The Trustee foundation is an independent body that oversees the International Accounting Standards Board (IASB) and the International Sustainability Standards Board (ISSB).

The Trustees are accountable to the Monitoring Board, a body of publicly accountable market authorities. The Trustees are not involved in any technical matters relating to IFRS Accounting Standards. This responsibility rests solely with the boards.

The IFRS Foundation Trustees focus on the needs of emerging economies and small and medium-sized entities. This includes profit and non-profit-making organisations such as charities.

Each Trustee member is expected to understand and is sensitive to international issues relevant to the success of an international organisation responsible for developing high-quality global accounting and sustainability disclosure standards for use in the world’s capital markets and by other users.

#International Accounting Standards Board (IASB)

The IASB is committed to developing, in the public interest, a single set of high-quality, understandable, and enforceable global accounting standards (IFRS Accounting Standards) that require transparent and comparable information in general-purpose financial reports.

The objective of general-purpose financial reports is to provide financial information about the reporting entity that is useful to primary users (investors and creditors).

The Board is also responsible for approving interpretations of IFRS Accounting Standards that the IFRS Interpretations Committee develops.

 Constitution

According to the IFRS Foundation Constitution:

• The IASB Board will typically comprise 14 members whom the trustees appoint. The primary qualifications are professional competence and recent relevant experience.
• The Board has:
  • complete responsibility for all board technical matters, including the issue of IFRS Accounting Standards (other than IFRIC Interpretations) and Exposure Drafts
  • complete discretion in developing the technical agenda for standard setting

Publishing standards, exposure drafts and final interpretations require a “supermajority”.

International Sustainability Standards Board (ISSB)

International investors with global investment portfolios are increasingly calling for high-quality, transparent, reliable and comparable reporting by companies on sustainability issues such as climate and other environmental, social and governance (ESG) matters.

In September 2020, the IFRS Foundation Trustees published a consultation paper to determine whether there is a need for international sustainability standards and whether the IFRS Foundation should play a role in developing such standards.

As a result, the Trustees announced the creation of a new board (ISSB) in November 2021 to meet the demand for sustainability standards.

ISSB’s role is to deliver comprehensive global sustainability-related disclosure standards that provide investors and other capital market participants with information about companies’ sustainability-related risks and opportunities.

The ISSB has set out four key objectives:

1. to develop standards for a global baseline of sustainability disclosures;
2. to meet the information needs of investors;
3. to enable companies to provide comprehensive sustainability information to global capital markets; and
4. to facilitate interoperability with disclosures that are jurisdiction-specific and/or aimed at broader stakeholder groups.

These objectives are very similar to the objectives stated by the International Accounting Standards Board (IASB) in that:

• They are aiming to produce a set of standards that will be accepted globally – in this case relating to sustainability, rather than financial information;
• The information requirements of the sustainability standards are primarily aimed at investors. The IASB states that financial reports prepared under IFRS Accounting Standards are primarily aimed at investors and creditors.
• The ISSB’s third objective, aiming to enable comprehensive sustainability information to global capital markets. The IFRS Foundation state that it was founded on the belief that better information supports better economic and investment decisions, so the ISSB’s third objective is consistent with this.
• The fourth objective is essentially about issuing standards that are compatible with existing regulations in different jurisdictions. The reason for the founding of the IASB was to reduce divergences in accounting practice across the globe by developing IFRS Accounting Standards that could be adopted globally. This objective is also consistent with the objectives of the IASB therefore, which aimed to set standards that would achieve global acceptance relating to financial information. A slight difference is in approach. The IASB effectively started with a clean slate, and wrote its own set of standards before aiming to achieve global acceptance of those standards. The ISSB has been building on the work of existing sustainability standards, such as the Climate Disclosure Standards Board and the Task Force for Climate-related Financial Disclosures.

The ISSB released its first two standards, IFRS S1 and IFRS S2 in June 2023. IFRS S1 deals with General Requirements for Disclosure of Sustainability-related Financial Information, while IFRS S2 deals with Climate-related Disclosures
IFRS Advisory Council (IFRSAC)
The IFRS Advisory Council advises the IFRS Foundation Trustees and the standards-setting boards (IASB and ISSB). Its members include investors, academics, auditors and members of local standard-setting bodies.

The board consults the IFRSAC on their agenda, priorities, and issues related to the application and implementation of IFRS Accounting Standards.

The Advisory Council comprises 30 or more members appointed by the trustees (for a renewable term of three years).

• The council provides a forum for participation by other interested parties (e.g. the Organisation for Economic Change and Development (OECD), the United States Financial Accounting Standards Board (FASB) and the European Commission).
• Its primary responsibility is to advise the standards-setting board on agenda issues, work priorities and the views of IFRS Advisory Council members on the development of standards projects.

IFRS Interpretations Committee (IFRS IC)
The IFRS IC reviews and provides guidance on issues arising when IFRS Accounting Standards have been implemented. These include the different ways of accounting for different types of transactions, doubt about correct accounting treatments or unclear disclosure requirements. The IFRS IC also provides guidance on issues not addressed in IFRS Accounting Standards.

The IFRS Interpretations Committee (IFRS IC) is the interpretative body of the IASB. The trustees appoint 14 voting members and a non-voting chairperson.

The committee’s responsibilities include:

• interpreting the application of IFRS Accounting Standards
• Provide timely guidance on financial reporting issues not explicitly addressed in IFRS Accounting Standards.

It publishes draft interpretations for public comment and considers comments before finalising them. It reports to the Board and obtains the Board’s approval for final interpretations.

Activity 1

Match the accounting body to the correct example of work carried out.

Global Accounting Standards
The International Accounting Standards Board (IASB) develops and publishes International Financial Reporting Standards (IFRS) Accounting Standards. Each standard is created to cover a specific aspect of accounting.

• The term IFRS Accounting Standards includes all standards and interpretations issued under the previous constitution (IASC) that the Board has approved.
• International Accounting Standards (IASs) and Interpretations issued by the Standards Interpretations Committee (SIC) that have been so approved continue to be applicable until they are withdrawn.

Objectives
IASB’s Mission Statement sets out its objectives: “To develop IFRS Standards that bring transparency, accountability and efficiency to financial markets around the world. Our work serves the public interest by fostering trust, growth and long-term financial stability”.

The goals of the IFRS Accounting Standards are to:

• bring transparencyby enhancing the international comparability and quality of financial information so investors can make informed economic decisions.
• strengthen accountabilityby reducing the information gap between the providers of capital (investors) and those to whom they have entrusted their money (management).

If the investors are not involved in the day-to-day business, they will not have access to the same information that managers have. Managers may exploit the differences in information for their benefit. IFRS Accounting Standards provide information that is needed to hold management to account.

• contribute to economic efficiencyby helping investors identify opportunities and risks worldwide, improving capital allocation. (A single, trusted accounting language lowers the cost of capital and reduces international reporting costs for businesses.)

Developing IFRS Accounting Standards
Due Process

IFRS Accounting Standards are developed through a due process which ensures that standard setting is transparent and considers a wide range of views from interested parties such as:

• accountants, financial analysts and other users of financial statements
• the business community
• stock exchanges
• regulatory and legal authorities
• academics
• other interested individuals and organisations throughout the world.

The Board consults the Advisory Council on significant projects, agenda decisions and work priorities and discusses technical matters in meetings open to public observation.

Project Development

Due process for projects typically, but not necessarily, involves the following steps:

• Setting the Agenda

When deciding what standards to develop, the IASB focuses on the relevance of the information to investors. It also looks at the availability of existing guidance and whether publishing an IFRS Accounting Standard will lead to adopting a common approach.

• Planning the Project

The IASB draws up a project plan. The board may develop the standard itself or with another standard setter, for example, the US standard-setting body, Financial Accounting Standards Board.

National accounting requirements and practices are studied, and the board exchanges views about the issues with national standard setters. The board consults with the Advisory Council about adding the topic to the Board’s agenda, and an advisory group (working group) is formed to advise the Board on the project.

• Developing and Publishing a Discussion Paper

A discussion paper is developed and published for public comment (also called a discussion document). The discussion paper gives an overview of the issues, such as a summary of possible approaches and the initial views of the authors.

A discussion paper must be approved by a majority of the Board’s members.

• Developing and Publishing an Exposure Draft
• After considering comments and dissenting opinions (alternative views) received, an exposure draftis developed. The draft is then published again for public comment. The IASB may publish a second exposure draft if comments identify significant issues.

An exposure draft must be approved by a supermajority of the Board:M

• Nine of the 14 members or
• Eight if there are 13 or fewer members

• Developing and Publishing an IFRS Accounting Standard

After the IASB has considered all the comments received and is satisfied that it has addressed all the points raised during the consultation process, it drafts the final version of the IFRS Accounting Standard. IASB then has the final draft externally reviewed and obtains approval from its members that it should be published.

• Procedures after an IFRS Accounting Standard is issued

After publication, the IASB may discuss with interested parties any unforeseen issues that have happened because of the IFRS Accounting Standard being applied. In time, the IASB may formally review the standard if, for example, the financial reporting and legal environment have changed.

Scope and Application
IFRS Accounting Standards apply to published financial statements of any commercial, industrial or business reporting entity (whether public or private sector).

• They apply to separate and consolidated financial statements (where applicable).
• Any limitation on the applicability of specific standards is made clear in an IFRS Accounting Standard.
• A standard applies from a date specified in the standard and is not retroactive (unless stated otherwise).
• Exclusions where IFRS Accounting Standards are not required to be applied:
  • Non-business aspects of public sector entities.
  • Private sector not-for-profit (NFP) entities.

Advantages and Disadvantages of IFRS Accounting Standards
The advantages of using IFRS Accounting Standards in preparing financial statements of a business include:

• Comparisons between businesses in different countries also using IFRS Accounting Standards will be easier.
• Foreign investors may trust financial statements prepared in compliance with IFRS Accounting Standards, meaning that companies find it easier to raise money from abroad.
• Companies operating in several countries can use IFRS Accounting Standards as a shared basis for preparing their financial statements.
• National authorities can adopt IFRS Accounting Standards as ready-made requirements without developing their guidance.
• Other organisations that operate internationally, for example, accountancy firms, will find it easier to deal with a common set of standards.

The disadvantages of using IFRS Accounting Standards in preparing financial statements of a business include:

• There will be costs involved in adopting IFRS Accounting Standards for the first time.
• IFRS Accounting Standards may not be as rigorous as national guidance in some areas.
• Adopting IFRS Accounting Standards may be challenging in some countries because some of its requirements may conflict with local law.

Introduction to Corporate Governance
Global Definitions

The Organisation for Economic Cooperation and Development (OECD) defines corporate governance as:

“The system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation and spells out the rules and procedures for making decisions on corporate affairs. It also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance.”

The Australian Securities Exchange defines corporate governance as:

“The system by which companies are directed and managed. It influences how the objectives of the company are set and achieved, how risk is monitored and assessed, and how performance is optimised. Good corporate governance structures encourage companies to create value (through entrepreneurism, innovation, development and exploration) and provide accountability and control systems commensurate with the risks involved.“

Concept of Corporate Governance

Corporate governance is a set of rules intended to create transparency and protect the interests of shareholders and stakeholders. It sets to prescribe the roles and responsibilities of directors as the stewards of the company, which helps align the directors’ interests with that of the shareholders.

The way corporate governance operates will vary significantly between companies. In some companies, the owner will own all the shares or a great majority of them, and corporate governance procedures will be simple. In other companies, no single party holds a majority of shares, but some financial institutions may have significant shareholdings.

Corporate governance mechanisms are needed to ensure that companies not only take account of the views of powerful shareholders with more considerable shareholdings but also act in the interests of shareholders owning a smaller proportion of shares.

The concept of corporate governance revolves around these three aspects:

• Risk Management

A company’s management must manage the level of risk the business faces and refrain from making decisions that will create uncontrollable risk. The management should also disclose to its stakeholders the existence and standing of faced risk in the financial statements. Companies should maintain sound internal control systems to manage their risk levels.

For example, a company having repeatedly breached lending covenants would be on the verge of having its borrowing facilities withdrawn. This constitutes poor risk management as such actions would affect its ability to trade.

• Quality of Information

The company’s management should ensure that proper accounting and information systems are in place to produce reliable financial statements. Information provided should be relevant, timely, accurate and represent a true and fair view of the company’s position.

For example, a company investing in accounting software to streamline its trading activities ensures that information is accurate and produced on time. The company employs proper corporate governance as the quality of information is secured.

• Stewardship

A company’s management should be open and transparent and present critical decisions on the business’s performance. They should also explain the overall strategy and their intentions for the future so that investors can decide whether these align with their expectations.

For example, a company portrays stewardship by providing financial information on how it has performed over the year and the strength of its asset base.

Corporate Governance and Financial Statements
The UK Corporate Governance Code (which applies to all listed companies but is also considered best practice for unlisted companies and non-corporate entities) states that:

• The board of directors must:
  • present a balanced and understandable assessment of the company’s position by issuing a set of financial statements
  • maintain a sound system of internal control concerning risk management
• An audit committee (consisting of at least three independent non-executive directors) must:
  • monitor the integrity of the financial statements
  • review the internal controls and risk management systems
  • monitor the internal and external auditors.

Duties and Responsibilities of Directors

The directors of a company have a fiduciary duty to act in good faith on behalf of the company. A business’s directors are responsible for preparing the financial statements, ensuring appropriate accounting systems are in place and keeping proper records.

Concerning financial statements, a company’s board of directors is collectively responsible for their:

• preparation every financial year to show a “true and fair view.”
• presentation to and approval by the shareholders.

To satisfy this responsibility, the directors should:

• Only approve the financial statements if they are satisfied that the financial statements give a true and fair view of the assets, liabilities, financial position and profit or loss
• State in the financial statements that the responsibility of preparing them lies with the directors
• Consider the appropriateness of their use of going concern principles and convey the message in the financial documents
• Explain the company’s business model and its strategy for delivering the objectives of the company in the financial statements
• Ensure that the financial statements are prepared per the form and content as prescribed by law and GAAP (e.g. IFRS Accounting Standards)
• Ensure that adequate accounting records are kept from which the financial statements are prepared.

The accounting records must be adequate to:

• show and explain the company’s transactions
• disclose the company’s financial position with reasonable accuracy
• prepare accounts which comply with the appropriate legal requirements
• show day-to-day entries of all sums of money received and paid (and the matters in respect of which the receipts and payments take place)
• record the company’s assets and liabilities

• Ensure that the financial statements are filed according to law. (For example, in the UK, public companies must file the financial statements with Companies House within six months after the reporting date.)

Other responsibilities of the directors of an organisation include:

• Prevention of Fraud – They have a duty to prevent and detect fraud. This goes beyond the financial statements, although misstatements may be made for fraudulent reasons.
• Cooperate with Auditors – Directors should cooperate with the company’s auditors and not collude, mislead or deceive them. They must provide the auditors with the information and explanations they need to conduct their audit.

In reviewing the financial statements, the external auditor should clearly state its independent position and ensure no conflict of interest is evident.

Audit Committee Responsibilities
An audit committee is a branch of a business’s board of directors that takes charge of a company’s financial reporting responsibilities and ensures internal controls are kept in place.

The responsibilities of the audit committee in a business include:

• Ensuring that the interests of shareholders are adequately protected concerning financial reporting and internal control.
• Monitoring the integrity of the financial statements and announcements relating to the company’s financial performance, including review of the significant financial reporting judgments made.
• Reviewing the company’s internal control, internal financial controls and risk management systems.
• Monitoring and reviewing the effectiveness of the internal audit function.
• Reviewing and monitoring the external auditor’s independence and objectivity and the effectiveness of the audit process.

Activity 2

State whether the following statements about governance guidance are true or false.

1. The auditors act as the directors’ agents when they audit the financial statements.
2. Under corporate governance best practice, both directors and auditors should state their responsibilities in the financial statements.
3. The auditors should state that the financial statements have been prepared on a going-concern basis.
4. To comply with the requirements of IFRS Accounting Standards, the directors should explain their strategy for delivering the company’s objectives.

Ethics and Governance

As well as being based on legal requirements, corporate governance is founded on a series of ethical concepts.

ACCA’s Code of Ethics and Conduct

The ACCA Code of Ethics and Conduct is binding on all ACCA members, students, and partners in an ACCA practice. The ethical concepts that apply to the preparation of accounting information are:

• Integrity

The Cadbury report on governance stressed that the integrity of reports depends on the integrity of those who prepare the reports. Integrity is about being straightforward. It means reporting financial information honestly, not misleading the users of financial statements, and producing a balanced picture of the company’s affairs.

• Objectivity

In preparing financial statements, accountants should be unbiased when they make judgements about what should be included in them. They should not be influenced by their self-interest or pressures from others towards distorting the financial statements.

• Professional Competence and Due Care

Accountants preparing or reviewing financial statements must have sufficient knowledge to do so properly. They also need to carry out their work carefully, avoiding errors.

• Professional Behaviour

Professional behaviour includes compliance with the laws and standards related to financial statements. It also has a broader meaning: avoiding behaving in a way that could generally damage the accounting profession’s reputation.

• Confidentiality

Confidentiality means respecting the confidential nature of information acquired through professional relationships. Confidential information should not be disclosed unless there is specific permission or a legal or professional duty.

Introduction to the Conceptual Framework

If the financial statements are to be useful to interested readers, the information contained in the financial statements should be reliable and of high quality.

This means the information must have specific characteristics and be prepared using certain assumptions. The conceptual framework guides these characteristics and assumptions.

Conceptual Framework Definition and Purpose

The conceptual framework is a statement of generally accepted assumptions and principles that provides a frame of reference for developing new practices and evaluating existing ones.

The purpose of the Conceptual Framework for Financial Reporting (Conceptual Framework) is to assist:

• the IASB (Board) in developing IFRS Accounting Standards
• the preparers of financial statements in developing consistent accounting policies
• all parties to understand and interpret the standards.

The Conceptual Framework is not a standard. Therefore, nothing in the Conceptual Framework can override a specific IFRS Accounting Standard.

Qualitative Characteristics of Financial Information
The Conceptual Framework for Financial Reporting identifies two fundamental qualitative characteristics and four enhancing qualitative characteristics relating to useful financial information.

The fundamental qualitative characteristics of useful financial information are:

• Relevance
• Faithful Representation

The Conceptual Framework also provides four enhancing qualitative characteristics of useful financial information are:

• Comparability
• Verifiability
• Timeliness
• Understandability

Relevance

Relevant information is information that is capable of influencing the decisions of users. For financial information to be relevant, one or both things must apply:

• The information needs to help the user form a view about what will happen to the business in the future
• the information confirms what has happened in the past.

Relevant information can be affected by its:

• Nature

Some items may be relevant to users simply because of their nature. For example, if a director has borrowed money from the company, the transaction must always be disclosed, even if the amount is small.

• Materiality

Information is material if its omission or misstatement could influence primary users’ decisions based on the financial information about the specific reporting entity.

Faithful Representation

Faithful representation means the financial statements describe financial events and conditions fairly in words and numbers. The information given should be:

• Complete(within bounds of materiality and cost) – Information reported should be complete as an omission can cause financial statements to be false or misleading and, therefore, unreliable.
• Neutral(free from bias)
• Free from error(no errors or omissions)

Faithful representation also means presenting the substance (the commercial effect) of an economic phenomenon rather than its legal form.

Comparability

Comparability means users should be able to make comparisons between information:

• about the same business in different periods
• between different businesses in the same period

Comparability requires consistent measurement and classification, and presentation of the financial effects of similar transactions and events.

Comparability does not always mean using the same methods to prepare information. Comparability implies that users must be informed (in the notes to the financial statements) of the principal accounting policies used, any changes to them and the effects of such changes.

Accounting policies – the specific principles, bases, conventions, rules and practices adopted by an entity in preparing and presenting financial statements.

Another implication of comparability is that financial statements must show corresponding information for preceding periods. In the financial statements of a business, another column of figures is present to show the financial information of the preceding year.

Verifiability

Verifiability means giving financial statements users confirmation that their financial information is faithfully represented.

Verifiability means that knowledgeable, independent observers can reach a consensus that a particular representation has the fundamental quality of faithfulness.

Timeliness

Timeliness links to relevance. For information to influence users’ decisions, it must be available when users make their decisions. However, other aspects may be affected if the information is reported quickly. For example, the information may not be complete and may have been prepared so fast that it is more likely to contain errors.

Information needs to be available in time for users to make decisions. Older information is generally less useful (but may still be useful in identifying and assessing trends).

Understandability

Understandability means showing information clearly and concisely. Some items in the financial statements are complicated. However, if they are omitted, the statements will be incomplete. Understandability also assumes that the users of the financial statements have some accounting knowledge.

Financial information should be made understandable through clear and concise classification and presentation.

• Users are assumed to have a reasonable knowledge of business and economic activities and accounting and a willingness to study information with reasonable diligence.
• Information about complex matters should not be excluded on the basis that it may be too difficult for certain users to understand.

Activity

Match the characteristics of good accounting information to the list of actions that preparers or users of financial information would take to ensure it displays those characteristics.

Accounting Principles
Accounting principles are the fundamental concepts accountants use to prepare financial statements. Standard-setting boards consider these principles when developing new frameworks and financial standards.

Materiality

The item’s nature and size are evaluated when determining whether the information is material. If the item’s non-disclosure could influence the economic decisions of users based on the financial statements, it is material.

Each material item should be presented separately in the financial statements. At the same time, immaterial amounts of a similar nature or function should be aggregated and need not be presented separately.

Offsetting

An entity shall not offset assets and liabilities or income and expenses unless required or permitted by an IFRS Accounting Standard.

An organisation should report assets, liabilities, income and expenses separately. Offsetting between these elements in the financial statements is not allowed unless the offsetting reflects the substance of the transaction.

Consistency

Consistency is needed to achieve comparability. It means treating and consistently presenting similar items in the financial statements over different periods unless there are appropriate reasons to make a change.

Reasons for change in the treatment of similar items could be due to the following:

• a significant change in its operations or
• if another classification provides a more suitable presentation of its transaction.
• Required by a new IFRS Accounting Standard

Changes in accounting policies need to be disclosed in the notes of financial statements.

Prudence

Prudence is the exercise of caution when making judgements under conditions of uncertainty. In preparing a business’s financial statements, assets and income should not be overstated, while liabilities and expenses should not be understated.

The main problem with exercising prudence is that it may result in the understatement of assets (and income) and the overstatement of liabilities (and expenses).

However, this is not allowed as this would conflict with the qualitative characteristic of faithful representation. Such misstatements would also lead to misstatements in future periods.

Duality (dual aspect)

Also known as the dual effect or dual aspect, the double entry concept explains that every transaction has at least two impacts on a business, a debit and credit entry.

Historical Cost and Current Value

The historical cost concept states that all transactions are initially recorded at historical cost, which is the cost at the time of the transaction. The historical cost system of accounting is particularly relevant to Assets.

Current value measures provide monetary information about assets, liabilities and related income and expenses, using information updated to reflect conditions at the measurement date.

Some bases of current value include:

• Fair value (price on an active market, or present value of future cashflows)
• Value-in-use (value derived from use of the asset)
• Current cost (value of an equivalent asset on measurement date)

Substance over Form

Substance over form is part of faithful representation. It means that the treatment of items in a company’s financial statements should be determined by their commercial reality and not by how they could be treated for legal purposes.

The concept is particularly relevant to assess:

• whether the definition of an element is met
• management’s assertions that elements of financial statements are complete, valid and accurate.

In most circumstances, substance and legal form are the same. If they are not, information about the legal form alone would not faithfully represent the economic substance. For example:

• A legal sale of an item of equipment may, in substance, be a lease.
• Sales to a customer may be paid for using the proceeds of a loan to the customer. When the transactions are considered together, the sale may be without substance.
• A sale of goods or services to a customer is made in exchange for purchasing a similar value of goods or services from the customer.

Whether the substance of a transaction should prevail over its legal form is a complex deliberation and depends on each transaction’s circumstances.

#Basis of Financial Statements Preparation
The financial statements are prepared by the management (directors) of a company with these three basic assumptions:

• The business is a going concern.

Going concern assumes that an entity will continue operating for the foreseeable future (the next 12 months). During that time, the company directors do not intend or will not be forced to liquidate the business or cease trading.

Going concern underlies the basis of the preparation of all published financial statements. It is so fundamental that users are entitled to assume that this basis has been applied unless an alternative basis is stated (in the notes to the financial statements).

• Accruals basis– The financial statements cover all transactions and events in the stated accounting period.

Transactions and events are recognised in a company’s accounting records when they happen and are not based on cash settlement.

The transactions or events will be included in the financial statements for the period they apply to. This may result in year-end accruals that are included within current liabilities in the financial statements.

The accruals basis links to the matching concept that expenses are recognised in the same accounting period as the revenues they relate to.

• Business Entity– The contents of the financial statement relate to the business.

The business is a separate entity from its owners/shareholders. The financial statements should only include transactions that relate to the business and not transactions that relate to the shareholders’ personal interests.

The business entity concept is an accounting concept, not a legal concept. Therefore, it applies to sole traders and partnerships even though the business and the owners are not legally distinct.

Activity 4

For each statement below, comment if it is true or false.

1. The materiality concept states that omitting or misstating information may influence the decisions of users of financial statements.
2. The accruals basis states that transactions should be accounted for when they are settled by cash.
3. Sarah is a sole trader. She has recently bought a car, which she does not use when on business. She has paid for the car through her business’s bank account and included the car as an asset in the business’s financial statements. This is a violation of the business entity concept.
4. The going concern concept implies that the business will continue operation for the longer term, at least the next five years.
5. Substance over form means that an accountant will account for a transaction according to its legal substance.
6. Consistency means that the same items must always be treated in the same way in the financial statements over different periods.
7. The application of prudence means expenses should consistently be recognised if there is any likelihood of them occurring, but accountants should be more cautious about recognising income.