Financial reporting - University of London · Presentation of financial information.. ... (HCA) and accounting for changing prices/values ... Final thoughts

Financial reportingJ. Haslam and D. ChowAC3091

2016

Undergraduate study in Economics, Management, Finance and the Social Sciences

This is an extract from a subject guide for an undergraduate course offered as part of the University of London International Programmes in Economics, Management, Finance and the Social Sciences. Materials for these programmes are developed by academics at the London School of Economics and Political Science (LSE).

For more information, see: www.londoninternational.ac.uk

The 2016 edition of this guide was prepared for the University of London International Programmes by:

Professor J. Haslam, Heriot-Watt University

and

Dr D.Chow, Durham University

It draws on previous editions of the guide prepared by J. Horton and S. Miles

Professor J. Horton, BSc, M Phil, PhD, Department of Accounting, University of Exeter Business School.

It was revised and updated in 2007 by:

S. Miles, PhD. Department of Accounting, The Business School, Oxford Brookes University.

This is one of a series of subject guides published by the University. We regret that due to pressure of work the authors are unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide.

University of London International Programmes

Publications Office Stewart House 32 Russell Square London WC1B 5DN United Kingdom

www.londoninternational.ac.uk

Published by: University of London

© University of London 2012

Reprinted with minor revisions 2016

The University of London asserts copyright over all material in this subject guide except where otherwise indicated. All rights reserved. No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher.

We make every effort to respect copyright. If you think we have inadvertently used your copyright material, please let us know.

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Contents

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Contents

Introduction ............................................................................................................ 1

Aims and objectives of this course ................................................................................. 1Learning outcomes ........................................................................................................ 1Syllabus ......................................................................................................................... 2How to use this guide .................................................................................................... 2Essential reading ........................................................................................................... 3Further reading .............................................................................................................. 4Online study resources ................................................................................................... 6Preparation for the examination ..................................................................................... 7Overview of the guide.................................................................................................... 8Index of abbreviations used in this guide ........................................................................ 9

Chapter 1: Rationale for financial reporting and its regulation .......................... 11

Aims of the chapter ..................................................................................................... 11Learning outcomes ...................................................................................................... 11Essential reading ......................................................................................................... 11Further reading ............................................................................................................ 11Financial accounting theory ......................................................................................... 12Financial accounting and its role .................................................................................. 13Financial accounting regulation ................................................................................... 15Accounting standards: what form should they take? ..................................................... 17Descriptions of accounting and its regulation ............................................................... 19UK accounting regulation and the influence of international accounting standards ....... 20Institutional setting for accounting regulation: the UK .................................................. 20Statutory regulation: IASs/IFRSs gained force of law ..................................................... 22Mandatory regulation: standard-setting and the case of the UK .................................... 23Stock Exchange ........................................................................................................... 25Reminder of learning outcomes.................................................................................... 26Sample examination questions ..................................................................................... 27

Chapter 2: Conceptual framework ....................................................................... 29

Aims of the chapter ..................................................................................................... 29Learning outcomes ...................................................................................................... 29Essential reading ......................................................................................................... 29Further reading ............................................................................................................ 29Definition of a conceptual framework ........................................................................... 30Rationale for a conceptual framework .......................................................................... 31Advantages claimed for a conceptual framework .......................................................... 31The US, IASC and UK initiatives compared .................................................................... 32Objectives of financial reporting ................................................................................... 33Qualitative characteristics of accounting information .................................................... 35Elements of financial statements .................................................................................. 38Recognition and measurement in financial statements SFAC 5, SOP .............................. 41Presentation of financial information ............................................................................ 44Review of the conceptual framework .......................................................................... 45Conclusions ................................................................................................................. 46

AC3091 Financial reporting

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Reminder of learning outcomes.................................................................................... 47Sample examination questions ..................................................................................... 47

Chapter 3: Income measurement and capital maintenance ................................. 49

Aims of the chapter ..................................................................................................... 49Learning outcomes ...................................................................................................... 49Essential reading ......................................................................................................... 49Further reading ............................................................................................................ 49A view of income and capital often characterised as the accountant’s view ................... 50A view of income and capital often characterised as the economist’s view .................... 50Hicks’s version of the economist’s concept of income .................................................... 51Hicks’s income number 1 ............................................................................................. 51Income ex ante and income ex post ............................................................................. 55What if interest rates are expected to change? ............................................................. 58Hicks’s income number 2 ............................................................................................. 60Hicks’s income number 3 ............................................................................................. 64Implications of Hicks’s measures of income .................................................................. 64Implications for accountants ........................................................................................ 65Reminder of learning outcomes.................................................................................... 66

Chapter 4: Historical cost accounting (HCA) and accounting for changing prices/values ......................................................................................................... 67

Aims of the chapter ..................................................................................................... 67Learning outcomes ...................................................................................................... 67Essential reading ......................................................................................................... 68Further reading ............................................................................................................ 68Introduction ................................................................................................................ 68Revising HCA .............................................................................................................. 69Characteristics of HCA ................................................................................................. 70Advantages of HCA ..................................................................................................... 70Disadvantages of HCA ................................................................................................. 71Alternatives to HCA ..................................................................................................... 73Introducing CPP accounting ......................................................................................... 73General and specific changes in price ........................................................................... 74Profit recognition and capital maintenance .................................................................. 74Assessing CPP accounting .......................................................................................... 75Converting from HCA to CPP: a step-by-step guide ...................................................... 76Worked example and explanation of CPP ..................................................................... 78Advantages of CPP ...................................................................................................... 82Disadvantages of CPP .................................................................................................. 82Introduction to current value accounting (CVA) ............................................................ 83Replacement cost accounting (RCA) ............................................................................. 83Net realisable value (NRV) ........................................................................................... 83Present value (PV) ....................................................................................................... 84Deprival value (DV) ...................................................................................................... 84Holding gains and current operating profit ................................................................... 87Capital maintenance concepts .................................................................................... 88Current value accounting using replacement cost ........................................................ 91Worked example and explanation of CVA ..................................................................... 91More on deprival value ................................................................................................ 96Advantages and disadvantages of replacement cost ................................................... 100Advantages and disadvantages of deprival value ........................................................ 101

Contents

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Combined CPP/CVA system ....................................................................................... 101Reminder of learning outcomes.................................................................................. 107Sample examination question .................................................................................... 108

Chapter 5: Accounting for groups ...................................................................... 111

Aims of the chapter ................................................................................................... 111Learning outcomes .................................................................................................... 111Essential reading ....................................................................................................... 111Further reading .......................................................................................................... 111Introduction .............................................................................................................. 112Key principles and rationales ...................................................................................... 113Requirement for consolidated accounts ...................................................................... 116Different models of group accounting ....................................................................... 117Different types of relationships within a group ......................................................... 118Accounting for subsidiaries ........................................................................................ 119Merger accounting .................................................................................................... 138Accounting for associates .......................................................................................... 138Accounting for joint ventures ..................................................................................... 142Discussion ................................................................................................................. 145Reminder of learning outcomes.................................................................................. 147Sample examination questions ................................................................................... 148

Chapter 6: Accounting for foreign currencies .................................................... 151

Learning outcomes .................................................................................................... 151Essential reading ....................................................................................................... 151Further reading .......................................................................................................... 151Introduction .............................................................................................................. 151Foreign currency conversion: business transactions ..................................................... 152Foreign currency translation: business transactions ..................................................... 153Which exchange rate should be used to record foreign currency translations? ............ 155Accounting for the closing rate method and the temporal method .............................. 157Final thoughts ........................................................................................................... 162Reminder of learning outcomes.................................................................................. 162Sample examination question .................................................................................... 163

Chapter 7: Accounting for tangible non-current assets ..................................... 165

Aims of the chapter ................................................................................................... 165Learning outcomes .................................................................................................... 165Essential reading ....................................................................................................... 165Further reading .......................................................................................................... 165Tangible non-current assets (owned) .......................................................................... 166Measurement of tangible non-current assets .............................................................. 166Borrowing costs ......................................................................................................... 167Measurement after recognition: revaluation ............................................................... 168Depreciation .............................................................................................................. 170Tangible non-current assets (not owned): leases ......................................................... 179Reminder of learning outcomes.................................................................................. 184Sample examination questions ................................................................................... 185

Chapter 8: Intangible assets: goodwill and R&D ................................................ 187

Aims of the chapter ................................................................................................... 187Learning outcomes .................................................................................................... 187Essential reading ....................................................................................................... 187Further reading .......................................................................................................... 187


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Introduction .............................................................................................................. 188Goodwill: the debate ................................................................................................. 188Intangible assets (other than goodwill) ...................................................................... 194Impairment: IAS 36 .................................................................................................... 197Research and development ........................................................................................ 198International differences ............................................................................................ 200Reminder of learning outcomes.................................................................................. 201Sample examination question .................................................................................... 201

Chapter 9: Accounting for inventories and construction contracts ................... 203

Aims of the chapter ................................................................................................... 203Learning outcomes .................................................................................................... 203Essential reading ....................................................................................................... 203Further reading .......................................................................................................... 203Components of inventory ........................................................................................... 203Implications of inventory for the accounts .................................................................. 204Inventory valuation: definitions ................................................................................. 206Implications of fair value accounting .......................................................................... 208Construction contracts ............................................................................................... 208Profit recognition methods ......................................................................................... 208Reminder of learning outcomes.................................................................................. 213Sample examination question ................................................................................... 213

Chapter 10: Accounting for equity and liabilities .............................................. 215

Aims of the chapter ................................................................................................... 215Learning outcomes .................................................................................................... 215Essential reading ....................................................................................................... 215Further reading .......................................................................................................... 215Share capital and reserves ......................................................................................... 216Ordinary shares ......................................................................................................... 216Preference shares ...................................................................................................... 216Accounting issues: equity or liability? ......................................................................... 217Off-balance sheet financing ....................................................................................... 225Reminder of learning outcomes.................................................................................. 226Sample examination questions ................................................................................... 227

Chapter 11: Accounting for taxation .................................................................. 229

Aims of the chapter ................................................................................................... 229Learning outcomes .................................................................................................... 229Essential reading ....................................................................................................... 229Further reading .......................................................................................................... 229An introduction to corporation tax systems ................................................................ 230UK: corporation tax.................................................................................................... 230Deferred taxation: taxable profit versus accounting profit ........................................... 233Three approaches to the accounting treatment of deferred tax.................................... 235Value-added tax (VAT) ............................................................................................... 238Reminder of learning outcomes.................................................................................. 238Sample examination question .................................................................................... 239

Chapter 12: Analysis and interpretation of financial reports ............................. 241

Learning outcomes .................................................................................................... 241Essential reading ....................................................................................................... 241Further reading .......................................................................................................... 241

Contents

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Introduction to the interpretation of financial statements ........................................... 241Ratio analysis – introduction ...................................................................................... 242Cash flow statement .................................................................................................. 246Trend analysis ............................................................................................................ 246International differences ............................................................................................ 247Reminder of learning outcomes.................................................................................. 249Sample examination questions ................................................................................... 250

Appendix 1: Solutions to activities and Sample examination questions ........... 251

Chapter 3 .................................................................................................................. 251Chapter 4 .................................................................................................................. 251Chapter 5 .................................................................................................................. 256Chapter 6 .................................................................................................................. 260Chapter 7 .................................................................................................................. 262Chapter 8 .................................................................................................................. 268Chapter 9 .................................................................................................................. 269Chapter 10 ................................................................................................................ 275Chapter 12 ................................................................................................................ 276

Appendix 2: Example of eight-column accounting paper .................................. 277

Notes


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Introduction

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Introduction

What is or should be the role of accounting in society? How important is or might be accounting in this respect? In what sense is and should accounting be regulated?

You may have encountered the financial accounting statements of companies, a major focus here, as part of your work or as a shareholder or other user. These statements will probably have been prepared by accountants and audited by an independent firm of auditors. The statements would still require some analysis by the user, for instance: Which figures are subject to management discretion? Which figures depend on accounting choice? How can you distinguish between two companies with identical earnings? How should accounting be regulated? Who should regulate or organise the production of accounting?

This subject guide is concerned with helping you to develop an understanding of financial accounting consistent with the aims and objectives of the course specified below.

Aims and objectives of this courseThe Financial reporting syllabus is concerned with the theory and practice of financial accounting. This involves a sound understanding of the concepts and choices that underlie measurement and disclosure in financial statements. The aims and objectives of the course are to:

• stimulate theoretical enquiry into financial accounting issues

• develop your knowledge and understanding of financial accounting

• prepare you for further academic study in accounting and related areas

• enable you to pursue a professional accountancy qualification

• equip you for employment in areas where an understanding of accounting issues and tools is helpful.

Learning outcomesAt the end of this course and having completed the Essential readings and activities, you should be able to:

• explain and apply a number of theoretical approaches to financial accounting

• record and analyse data

• prepare financial statements under alternative accounting conventions

• describe a number of regulatory issues relating to financial accounting

• critically evaluate theories and practices of, and other matters relating to, financial accounting.

The learning outcomes that you are expected to achieve for the various topics are listed at the end of each chapter.


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SyllabusThe rationale for financial reporting. Arguments for and against regulation of financial reporting. Methods of regulation, including standardisation of accounting practices. The nature and purposes of a conceptual framework for financial reporting: the objectives of financial reporting; the qualitative characteristics of accounting information; the definitions of an asset and a liability; recognition and measurement in financial statements; international framework. Narrative reporting and issues of corporate social responsibility. Economic and accounting concepts of income, capital and value with particular reference to Hicks’s income concepts.

Strengths and weaknesses of historical cost accounting. Bases of asset valuation. Capital maintenance concepts and various associated techniques: current value accounting systems, current purchasing power accounting, replacement cost accounting; in addition to entry (historical cost) and exit value accounting.

Accounting for investments and groups of companies. The merger and acquisition methods. Associated companies and joint ventures. Accounting for foreign currency transactions, foreign subsidiaries and branches: the temporal and closing rate/net investment methods of foreign currency translation.

Accounting for tangible and intangible assets: fixed assets and depreciation; stocks and long-term contracts; research and development; goodwill. Accounting for leases. Accounting for liabilities. Accounting for taxation, including deferred taxation.

Analysis and interpretation of corporate financial reports; introduction to international differences in financial reporting.

Accounting standards in this subject guide This subject guide is written for International Programmes students, who will be studying in many different countries subject to different accounting rules and regulations. The International Accounting Standards Board (IASB) is quickly becoming the generally accepted accounting regulator at the international level. In the EU and Australia, for example, all listed companies are required to produce group financial statements in accordance with current International Accounting Standards (IASs) and International Financial Reporting Standards (IFRSs) – the latter are gradually replacing the former as the IASs come to be updated and revised. Many other countries such as the USA and China are working towards closing the convergence gap between IASs/IFRSs and national regulations. This subject guide has been written with this in mind. The subject guide has an international focus but within that we give some particular consideration to the UK (e.g. in the context of accounting for changing prices) because it serves to illustrate some key developments.

All worked examples use £ sterling as the currency. A list of abbreviations reflecting the emphases of the guide is given at the end of the Introduction.

How to use this guideThis subject guide is intended to supplement the Essential reading, not to replace it. It should be read in conjunction with the Essential reading and supported by Further reading. The list of Further reading is a selection from many possible sources. Please seek additional reading on any topics that you find difficult to grasp. Please note that, given the rapid

Introduction

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pace of change in financial accounting, you should use the latest editions of texts, particularly the Essential reading text for the course.

In addition to the Essential reading listed at the beginning of each chapter, you should read the appropriate available accounting practitioner journal (e.g. Accountancy and Certified Accountant in the UK). Journals of other professional accountancy bodies in other countries are just as relevant.

It may also be useful for you to obtain a copy of the Annual Reports and Accounts of a large company in your country. This will provide you with a good reference aid for some of the main issues addressed in this guide. You can generally obtain these reports on the company’s website. Alternatively you could write to the company asking for a copy of their report.

WebsitesIt is also recommended that you use the internet and investigate the different professional bodies and government organisations’ websites which are a useful source of information on current developments in financial reporting and regulation. Examples include:

• www.frc.org.uk for the UK Accounting Standards Board (ASB)

• www.fasb.org for the US Financial Accounting Standards Board (FASB)

• www.iasb.org.uk for the International Accounting Standards Board (IASB).

Unless otherwise stated, all websites in this subject guide were accessed in April 2012. We cannot guarantee, however, that they will stay current and you may need to perform an internet search to find the relevant pages.

ActivitiesThis subject guide is divided into 12 chapters, the majority of which are self-contained. Most chapters contain worked numerical examples, where appropriate, and activities appear throughout the guide. It is strongly recommended that you attempt to answer, or consider the implications of, all activities. Many of them require you to do additional reading. Solutions to some of the activities and sample examination questions are available in Appendix 1 at the back of the guide.

Sample examination questionsThere are sample examination questions at the end of each chapter, aimed to test your knowledge and prepare you for the examination. However, the Sample examination paper, found on the virtual learning environment (VLE), is a more accurate reflection of the type of questions that are likely to come up in the examination.

Reading adviceThere is no single wholly satisfactory textbook covering all the topics discussed in this course. References are given to one of the main advanced financial accounting textbooks. References for specific Further reading will also be given where appropriate. You are advised to check if new editions of these textbooks are available.

Essential readingAlexander, D., A. Britton and A. Jorissen International Financial Reporting

and Analysis. (Andover: Cengange Learning EMEA, 2011) fifth edition [ISBN 9781408032282]. Hereafter, we will refer to this book simply as International Financial Reporting.

http://www.frc.org.uk

http://www.fasb.org

http://www.iasb.org


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Detailed reading references in this subject guide refer to the editions of the set textbooks listed below. New editions of one or more of these textbooks may have been published by the time you study this course. You can use a more recent edition of any of the books; use the detailed chapter and section headings and the index to identify relevant readings. Also check the VLE regularly for updated guidance on readings.

Further readingPlease note that as long as you read the Essential reading you are then free to read around the subject area in any text, paper or online resource. You will need to support your learning by reading as widely as possible and by thinking about how these principles apply in the real world. To help you read extensively, you have free access to the VLE and University of London Online Library (see below).

Other useful texts for this course include:

Collins, B. and J. McKeith Financial Accounting and Reporting. (London: McGraw-Hill, 2010)[ISBN 9780077114527].

You might find it helpful to refer to a dictionary of accounting when you encounter a new term. Two such dictionaries are:

Nobes, C. The Penguin Dictionary of Accounting. (London: Penguin Books Ltd, 2006) second edition [ISBN 9780141025254].

Owen, G. Dictionary of Accounting. (Oxford: Oxford University Press, 2005) third edition [ISBN 9780192806277].

It is also recommended that you purchase or have access to the following reference texts:

Deegan, C. and J. Unerman Financial Accounting Theory. (London: McGraw-Hill, 2011) second European edition [ISBN 9780077126735].

Glautier, M.W.E., B. Underdown and D. Morris Accounting Theory and Practice. (Harlow: Financial Times Prentice Hall, 2011) eighth edition [ISBN 9780273693857]. Please note that this is the Essential reading for 25 Principles of accounting so you may already own a copy.

Lewis, R. and D. Pendrill Advanced Financial Accounting. (Harlow: Financial Times Prentice Hall, 2004) seventh edition [ISBN 9780273658498].

Palepu, K.G., and P.M. Healy Business Analysis and Valuation: Using Financial Statements. (Mason, OH: Thomson South-Western, 2008) fourth edition [ISBN 9780324302929].

Suitable international texts for reference include:

Nobes, C. and R. Parker Comparative International Accounting. (Harlow: Financial Times Prentice Hall, 2012) twelfth edition [ISBN 9780273763796].

Choi, F.D. and G.K. Meek International Accounting. (Harlow: Pearson, 2012) seventh edition [ISBN 9780132311496].

Those of you who have studied 25 Principles of accounting may find it useful to keep your subject guide to hand as you study this course.

The following is a list of all other reading listed in the Further reading category in the subject guide:

Baxter, W.T. Depreciation. (London: Sweet & Maxwell, 1971) [ISBN 042114470X].

Baxter, W.T. Inflation Accounting. (Oxford: Philip Allan, 1984) [ISBN 9780860036234] Chapters 3, 8 (pp.103–15) and 12 (pp.182–201).

Beaver, W.H. and J.S. Demski ‘The Nature of Income Measurement’, Accounting Review 54(1) 1979.

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Baxter, W.T. ‘Accounting Standards – Boon or Curse’, Accounting and Business Review, Winter 1981, pp.3–10.

Beaver, W.H. Financial Reporting: An Accounting Revolution. (Harlow: Prentice-Hall, 1981) [ISBN 9780133161335]. Chapter 7.

Bromwich, M. Financial Reporting, Information and Capital Markets. (London: Pitman Publishing, 1992) [ISBN 9780273034643] Chapters 3, 4, 10–12. (Although this focuses specifically on the FASB’s Conceptual Framework, it also discusses a number of issues about the conceptual framework approach that can be considered in relation to the IASB’s Framework for the Preparation and Presentation of Financial Statements and the ASB’s Statement of Principles.)

Cadbury report (1992). Available at www.iia.org.uk – search for ‘Cadbury report’.Company Law Review Steering Group, Company Law Reform. Modern Company

Law for a Competitive Economy: Developing the Framework. Available at www.berr.gov.uk/files/file23245.pdf

Draper, P.R., W.M. McInnes, A.P. Marshall and P.F. Pope ‘An Assessment of the Effective Annual Rate Method as a Basis for Making Accounting Allocations’, Journal of Business Finance & Accounting 20(1) 1993, pp.56–63.

Ernst and Young, International GAAP 2012: Generally Accepted Accounting Practices under International Reporting Standards. (Chichester: John Wiley & Sons, 2012) [ISBN 9781119962458].

Gallhofer, S. and J. Haslam, ‘Exploring social, political and economic dimensions of accounting in the global context: the IASB and accounting disaggregation’, Socio-Economic Review 8(4) 2007, pp. 633–64.

Hicks, J.R. ‘Income’ in Parker, R.H., G.C. Harcourt and G. Whittington (eds) Readings in the Concepts and Measurements of Income. (Oxford: Philip Allan, 1986) second edition [ISBN 9780860035367].

Hicks, J.R. Value and Capital. (Oxford: Clarendon, 1946) second edition [ISBN 9780198282693] Chapter 14.

Holmes, G., A. Sugden and P. Gee Interpreting Company Reports and Accounts. (Harlow: Prentice-Hall, 2008) tenth edition [ISBN 9780273711414] Chapters 4, 10 and 11.

Ijiri, Y. ‘A Defence for Historical Cost Accounting’ in R. Sterling (ed.) Asset Valuation and Income Determination. (Lawrance, KA: Scholars Book Co., 1971) [ISBN 9780914348115].

Macve, R. ‘Accounting for Long-Term Loans’, in B. Carsberg and S. Dev (eds) External Financial Reporting. (Harlow: Prentice Hall, 1984).

Macve, R. A Conceptual Framework For Financial Accounting and Reporting: the Possibilities for an Agreed Structure. (London: Institute of Chartered Accountants in England and Wales, 1981) [ISBN 9780852913116].

Paish, F.W. ‘Capital and Income’, Economica 7(28) 1940. Peerless, S. ‘Accounting for Business Marriages’, Accountancy Magazine, October

1994, p.100.Prakesh, P. and S. Sunder ‘The Case Against Separation of Current Operating

Profit and Holding Gains’, American Accounting Review, January 1979 (pp.1–22).Sandilands Report, Inflation Accounting: Report of the Inflation Accounting

Committee, Cmnd. 6225 (London: HMSO, 1975). Chapters 10 and 12 (pp.159–65).

Scott, W. Financial Accounting Theory. (London: Prentice-Hall, 2011) [ISBN 9780135119150].

Smith, T. Accounting for Growth. (London: Century, 1996) second edition [ISBN 9780712675949]. Chapter 16.

Solomons, D. ‘Economic and Accounting Concepts of Income’, Accounting Review 36(3) 1961 (reprinted in Parker, R.H., G.C. Harcourt and G. Whittington (eds) Readings in the Concepts and Measurements of Income. (Oxford: Philip Allan, 1986) second edition [ISBN 9780860035367].

http://www.iia.org.uk


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Weetman, P. (ed.) SSAP 15 Accounting for Deferred Taxation. (Edinburgh: The Institute of Chartered Accountants of Scotland, 1992) [ISBN 9781871250237].

Whittington, G. Inflation Accounting: An Introduction to the Debate. (Cambridge: Cambridge University Press, 1983) [ISBN 9780521270557].

Online study resourcesIn addition to the subject guide and the Essential reading, it is crucial that you take advantage of the study resources that are available online for this course, including the VLE and the Online Library.

You can access the VLE, the Online Library and your University of London email account via the Student Portal at: http://my.londoninternational.ac.uk

You should have received your login details for the Student Portal with your official offer, which was emailed to the address that you gave on your application form. You have probably already logged in to the Student Portal in order to register! As soon as you registered, you will automatically have been granted access to the VLE, Online Library and your fully functional University of London email account.

If you have forgotten these login details, please click on the ‘Forgotten your password’ link on the login page.

The VLEThe VLE, which complements this subject guide, has been designed to enhance your learning experience, providing additional support and a sense of community. It forms an important part of your study experience with the University of London and you should access it regularly.

The VLE provides a range of resources for EMFSS courses:

• Electronic study materials: All of the printed materials which you receive from the University of London are available to download, to give you flexibility in how and where you study.

• Discussion forums: An open space for you to discuss interests and seek support from your peers, working collaboratively to solve problems and discuss subject material. Some forums are moderated by an LSE academic.

• Videos: Recorded academic introductions to many subjects; interviews and debates with academics who have designed the courses and teach similar ones at LSE.

• Recorded lectures: For a few subjects, where appropriate, various teaching sessions of the course have been recorded and made available online via the VLE.

• Audiovisual tutorials and solutions: For some of the first year and larger later courses such as Introduction to Economics, Statistics, Mathematics and Principles of Banking and Accounting, audio-visual tutorials are available to help you work through key concepts and to show the standard expected in exams.

• Self-testing activities: Allowing you to test your own understanding of subject material.

• Study skills: Expert advice on getting started with your studies, preparing for examinations and developing your digital literacy skills.

http://my.londoninternational.ac.uk

Introduction

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Note: Students registered for Laws courses also receive access to the dedicated Laws VLE.

Some of these resources are available for certain courses only, but we are expanding our provision all the time and you should check the VLE regularly for updates.

Making use of the Online LibraryThe Online Library (http://onlinelibrary.london.ac.uk) contains a huge array of journal articles and other resources to help you read widely and extensively.

To access the majority of resources via the Online Library you will either need to use your University of London Student Portal login details, or you will be required to register and use an Athens login.

The easiest way to locate relevant content and journal articles in the Online Library is to use the Summon search engine.

If you are having trouble finding an article listed in a reading list, try removing any punctuation from the title, such as single quotation marks, question marks and colons.

For further advice, please use the online help pages (http://onlinelibrary.london.ac.uk/resources/summon) or contact the Online Library team: [email protected]

Changes to the syllabusThe material contained in this subject guide reflects the syllabus for the year 2016–17.

The field of accounting changes regularly, and there may be updates to the syllabus for this course that are not included in this subject guide. Any such updates will be posted on the VLE. It is essential that you check the VLE at the beginning of each academic year (September) for new material and changes to the syllabus. Any additional material posted on the VLE will be examinable.

Preparation for the examinationImportant: the information and advice given here are based on the examination structure used at the time this guide was written. Please note that subject guides may be used for several years. Because of this we strongly advise you to always check both the current Programme regulations for relevant information about the examination, and the VLE where you should be advised of any forthcoming changes. You should also carefully check the rubric/instructions on the paper you actually sit and follow those instructions.

With regard to this subject guide, you should:

• refer to the Essential reading and any Further reading you might require to fully understand the topics in the syllabus

• attempt all the activities in each chapter

• complete all the sample examination questions.

We also recommend that you read through the section on examinations in Strategies for success. It contains some useful guidelines on preparing for examinations.

http://onlinelibrary.london.ac.uk

http://onlinelibrary.london.ac.uk/resources/summon

http://onlinelibrary.london.ac.uk/resources/summon

mailto:onlinelibrary%40shl.london.ac.uk?subject=


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Remember, it is important to check the VLE for:

• up-to-date information on examination and assessment arrangements for this course

• where available, past examination papers and Examiners’ commentaries for the course which give advice on how each question might best be answered.

Format of the examinationThe examination could cover any of the subjects that are addressed in this syllabus. The examination is three hours long, and you are normally required to answer four questions from a choice of seven. These will be a mixture of essay-style questions and computation with discussion questions. You therefore need to concentrate on both the qualitative and quantitative characteristics of the topics. You cannot rely purely upon, for example, the computation aspects to pass the examination. The entire syllabus is examinable. Appendix 1 contains solutions to activities and to Sample examination questions. Note that solutions are available only for selected activities and questions. Sample examination papers can be found on the VLE.

The examination also has an additional 15 minutes which is given as reading time. You may begin writing at any point after the start of the examination (which remains three hours in length). The total time available to you in the examination hall will therefore be 3 hours and 15 minutes.

Overview of the guideAs emphasised throughout this subject guide, accounting is a communication tool. The business entity communicates financial information to interested parties (e.g. potential and existing shareholders, creditors, managers, employees, NGOs, suppliers, the government, etc.) in the form of financial statements. These financial statements will in themselves impart information about the economic resources of the entity which are under the control of management.

Policy-makers (e.g. standard-setters) and others helping to shape accounting (including practising accountants) have to ask themselves a number of basic questions before they can even begin to construct the financial statements. For example:

• Which disclosures and figures should be included in these Financial accounting statements? How much detail should be given?

• How should these figures be calculated?

• Who are the users of this information?

• Will they find the figures useful for their decisions and purposes? What is accounting’s role?

T. Smith quotes an old joke which summarises some criticisms of accounting:

An old man was lost in a hot air balloon. Fortunately he saw someone walking in a field below him so he lost height and when he was within range shouted ‘Can you tell me where I am?’ The walker stopped, paused for thought and shouted back ‘You’re in a hot air balloon.’ ‘You must be an accountant’ retorted the balloonist. ‘Amazing’, said the walker. ‘How did you know that?’ ‘Because the information you just gave me was both totally accurate and completely useless!’ (Smith, T. Accounting for Growth, 1996, p.73)

Introduction

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Chapter 2 of this subject guide addresses some key accounting issues:

• What is and should be accounting’s role in society?

• Who are the users?

• What information would they benefit from?

• What should the underlying criteria be: relevant information, reliable information, or both (if possible)?

• In what sense is or should accounting be regulated?

The remaining chapters consider a number of basic questions and issues that have been debated over the years when deciding upon which disclosures and figures should be reported in the accounts, for instance:

• What alternative measurement methods are available?

• Will they capture the underlying economic reality of the business?

• Will they be useful and understandable to users?

• Will the figures enable users to make optimal decisions concerning the allocation of their own scarce economic resources?

• What do the standard-setters believe firms should be measuring and reporting, and why?

• Are the standards theoretically and conceptually correct in requiring companies to report and measure certain figures?

• Are the methods appropriate given the environment in which companies now operate?

• What issues still need to be addressed and why?

Chapters 3–4 deal with income measurement and capital maintenance (and also consider economic approaches, such as those proposed by Hicks), historical cost accounting, current purchasing power accounting and current value accounting. Chapters 5–12 are firmly based upon the modified historical cost/mixed measurement systems relating possibilities to the Hicks income concepts. We discuss the implications of Hicksian theory and would also recommend Biekpe, N., M. Tippett and R. Willett ‘Accounting Earnings, Permanent Cash Flow And The Distribution Of The Earnings To Price Ratio’, The British Accounting Review 30(2) 1998, pp.105–40. We are concerned to point to the relevance of context and seek to broaden horizons on financial accounting. We consider possible futures for accounting.

Index of abbreviations used in this guide

AEC Annual equivalent costs

ASB Accounting Standards Board

CBS Consolidated Balance Sheet

CIS Consolidated Income Statement

CPP current purchasing power

CVA current value accounting

DV deprival value, also known as ‘value to the business’ or ‘value to the owner’.

EPS earnings per share

EC European Community


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EU European Union

FASB Financial Accounting Standards Board

FIFO first-in, first-out

FPPFS Framework for the Preparation and Presentation of Financial Statements

FRS Financial Reporting Standard

GPP General Purchasing Power

HCA Historical Cost Accounting

IAS International Accounting Standard

IASB International Accounting Standards Board

IASC International Accounting Standards Committee

IFRS International Financial Reporting Standard

IOSCO International Organization of Securities Commissions

LIFO last-in, first-out

NBV net book value

NPV net present value

NRV net realisable value, also known as ‘current exit value’

P/E price/earnings ratio

PV present value, also known as ‘economic value’

RC replacement cost, also known as ‘current entry cost’

ROCE return on capital employed

RPI Retail Price Index

SEC Securities and Exchange Commission

SOP Statement of Principles

SSAP Statement of Standard Accounting Practice

Chapter 1: Rationale for financial reporting and its regulation

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Aims of the chapterThis chapter introduces:

• the role of accounting in society

• the regulatory framework (discussion focused upon the international framework)

• arguments for and against forms of accounting regulation, including voluntary disclosure.

Learning outcomesBy the end of this chapter, and having completed the Essential reading and activities, you should be able to:

• delineate the basic character of financial accounting theory

• discuss the role of accounting in society

• explain the different levels of authority in the UK regulatory framework

• explain and discuss the implications of the International Accounting Standards Board (IASB)

• discuss the arguments for and against accounting standards

• discuss the theory of regulation.

Essential readingInternational Financial Reporting, Chapter 1.

Further readingBaxter, W.T. ‘Accounting Standards – Boon or Curse’, Accounting and Business

Review, Winter 1981, pp.3–10. Beaver, W.H. Financial Reporting: An Accounting Revolution. (Harlow: Prentice-

Hall, 1981) [ISBN 9780133161335]. Chapter 7.Bromwich, M. Financial Reporting, Information and Capital Markets. (London:

Pitman Publishing, 1992) [ISBN 9780273034643]. Chapters 10 and 11.Cadbury report (1992); this can be viewed on the internet. See the website for

the Institute of Internal Auditors: www.iia.org.uk followed by a search for ‘Cadbury report’.

Deegan, C. and J. Unerman Financial Accounting Theory. (London: McGraw-Hill, 2011) second European edition [ISBN 9780077126735] Chapters 1–4.

Gallhofer, S. and J. Haslam, ‘Exploring social, political and economic dimensions of accounting in the global context: the IASB and accounting disaggregation’, Socio-Economic Review 8(4) 2007, pp. 633–64.

Lewis, R. and D. Pendrill Advanced Financial Accounting. (Harlow: Financial Times Prentice Hall, 2004) seventh edition [ISBN 9780273658498] Chapters 1–3.

Scott, W. Financial Accounting Theory. (London: Prentice-Hall, 2011) [ISBN 9780135119150].

http://www.iia.org.uk


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Financial accounting theoryWhat is financial accounting? There are different understandings of it.

Some would equate it to ‘external accounting’, which indicates an accounting that, in the case of the business firm, goes outside the organisation to owners not closely involved in internal business management or into the broader public realm. This is potentially a quite broad understanding of financial accounting. Interestingly, it could actually go beyond the financial, if including it, and may reflect very old notions of rendering an account more generally.

A common, narrower usage understands financial accounting to be external and financial. In most university courses on financial accounting there is a further narrowing with the typical focus being on the commercial business organisation that is owned by shareholders who are understood to be other than the company’s management. Financial accounting, where it is seen as external, which is usually the case, is often distinguished from internal ‘management accounting’.

In broad terms, all accounting can be understood in terms of decision making and control roles (where these encompass dimensions of accountability and stewardship).

The relation between financial accounting and financial reporting is also not a settled one. In some usages they are taken to be the same or at least substantively so. In others, the accounting implies a broader activity (e.g. recording) and reporting is understood as a branch of it. In yet other usages, financial reporting equates to a broader external reporting that need not be restricted to the financial whereas financial accounting (or simply accounting) is understood to be so restricted. In trying to introduce the subject matter, it is appropriate to give insight into these nuances that are found in what is a quite diverse literature on accounting. Both financial reporting and financial accounting may be distinguished from financial statements in perhaps including narrative reports.

In this subject guide, we shall typically equate financial accounting and financial reporting and where we intend a different connotation we shall make that explicit. Often, reflecting much of the literature and practice, we shall use the term financial accounting where we mean the external and financial accounting of organisations (typically commercial business organisations) but we shall give some recognition to broader definitions (e.g. in referring to some notions of corporate social responsibility accounting) and in those cases make clear that we are departing from the narrower view. We shall adopt the broad understanding of accounting’s role. But here we need to introduce a further framework for understanding. Controversies do not end with issues of definition or delineation.

The study of financial accounting (whether understood broadly or narrowly) is the study of a social phenomenon. Accounting is constructed by people in a context and impacts upon them and the context. Presumably its justification is in terms of social well-being.

The study of accounting may clearly be seen, and is typically understood, as a social science. One common way of classifying theories in the social sciences (e.g. in economics) is to distinguish between normative and positive approaches, or (as is preferred here) between prescriptive and descriptive approaches. Prescriptive approaches are concerned with developing a theory of accounting ‘as it should be’ and descriptive approaches with developing a theory of accounting ‘as it is’.


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In this subject guide we give insights into the more prescriptive and the more descriptive approaches. Again, there are different approaches within this broad categorisation. For instance, there are those who draw primarily from economics in formulating either prescriptive or descriptive theories of accounting. And one should note here that there are different views within economics! Others draw from sociology or adopt a more interdisciplinary perspective. The latter approach overlaps with concerns to understand financial accounting more broadly and especially in terms of its scope, the variety of influences upon it and its diverse consequences. Many academics and policy-makers consider mainstream economic theory to be a good basis for theorising financial accounting prescriptively and descriptively while for others it is a narrow approach that does not take into account the actual and potential repercussions of financial accounting. We shall try to give insights into major instances of the more economistic approaches and other approaches and also here try to build bridges between them. We shall thus begin to explore how accounting’s role has been variously theorised prescriptively, e.g. as improving economic decisions so as to enhance social welfare or as contributing to a better democracy and shall consider descriptive studies of accounting so as to also reflect the diverse approaches of the literature.

In this chapter we consider prescriptive views that have emerged in relation to issues of accounting’s regulation. We shall see that many views here reflect mainstream economistic thinking. We offer descriptions of financial accounting practice and its context in the UK and internationally, with again an emphasis on how financial accounting is regulated. It becomes clear here that a mainstream economistic thinking has been influential in the construction of a regulatory framework with linked institutions in this area. We also give some attention to ways of seeing beyond the economistic.

Financial accounting and its roleMainstream economistic views see financial accounting as information that guides economic decisions. Actually, in many abstract models that are not uncommon in economic reasoning, perfect information is simply taken to exist.

To the extent that information in general and financial accounting in particular are considered more realistically, the approaching of perfect information is often taken as desired. As the information increases in quality (a notion encompassing increased transparency) economic decisions are understood to improve. Perhaps more detailed, disaggregated information could be given. Perhaps companies could be valued better or report better their value. The view is that scarce resources are better allocated in the economy and social welfare increased.

A modification of this position again in the direction of greater realism appreciates that information is costly. Its benefits should exceed its costs.

Substantively, the latter are ostensibly the dominant views of the influential accounting policy-makers. The IASB, for instance, emphasises the role of financial accounting information in guiding economic decisions and thus enhancing social welfare. Less frequently in official pronouncements but often used to justify actual policy decisions, explicit reference is made to the costliness of this or that possible provision (although the UK’s ASB does make reference to it in its stated aims – as well as pointing out that it is not in favour of revolutionary changes to financial reporting!).


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Those giving thought to further dimensions of the imperfect character of real world economies have added further layers of complexity in their prescriptions. The assumption that more transparency is better than less is brought into question beyond simple cost-benefit analysis. Lipsey and Lancaster (1957) argue that in imperfect market contexts, improving information without improving other aspects of the economic system might even reduce social welfare. Possible reasons include that in a competitive economy businesses need to have incentives to innovate that might be countered if too much is made transparent. Thus, even shareholders have an interest in keeping some information within the firm. If more information is publicly available it may be easier for monopolistic firms to strengthen monopolistic positions, to the detriment of social welfare (Gallhofer and Haslam, 2007).

Such considerations may help us with descriptive theory. Factors such as the above, together with information’s costliness, as well as lack of shareholder control over corporate management, may explain why many commentators believe that financial accounting information falls short of the information that one might assume, from a more mainstream position, capital providers would want (Tinker, 1985, even refers to shareholder alienation). This is in spite of the apparent shareholder and investor orientation of the influential policy-makers. Perhaps it is the case that financial accounting does reflect the conventionally assumed interests of shareholders – but in an imperfect market – or perhaps those interests are only partially or imperfectly satisfied.

Returning to prescription, another view from someone well versed in an information economics perspective takes further the notion of imperfect markets (towards an appreciation of the imperfect character of the socio-economic and political context) and fuses with a more interdisciplinary perspective, indicating that financial accounting cannot be understood to have only narrowly conceived economic consequences. Joseph Stiglitz, a Nobel prize winner in economics, notes that when information like financial accounting enters the public realm it enters a complex context of conflicting forces. One cannot assume that information produced for purpose X will not be used for purpose Y. Purpose Y may include the desire to impose stricter regulations on business and/or enhance the general democratic control over business. The prescriptive implication may not be so clear but the suggestion is that some kind of trade off may be necessary in an imperfect context.

Drawing from such an insight, some researchers point to financial accounting’s role in potentially changing (for the better) the character of the socio-political and economic system as well as serving it (Gallhofer and Haslam, 2007). Similar prescriptive thinking is behind other socio-economic and socio-political theorising, in which forms of corporate social responsibility accounting are envisioned that transform the narrower economistic financial accounting towards a more holistic form of accounting that reflects (from their perspectives) all things of relevance to social well-being (in relation to corporate operations). More generally, the concern for a more holistic external accounting involves going beyond mainstream perceptions and includes prescriptions of non-financial information (see Gallhofer and Haslam, 2007).

These prescriptive suggestions have had little influence on accounting policy-makers, although The Corporate Report (1975), a draft policy statement of the UK Accounting Standards Steering Committee (a forerunner of today’s UK ASB), did put forward a stakeholder-orientated form of external accounting that included non-financial as well as financial information. It never became a standard (Gallhofer and Haslam, 2007).


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Financial accounting regulationMainstream economistic reasoning has also been influential in respect of the issue of how best to regulate financial accounting. Some of the above perspectives have implications for how accounting should be regulated.

Perspectives that assume the existence of perfect information clearly would not see the need for further regulation. Under the scenario of perfect and complete markets, a company that accepted all projects with non-negative present values would simply have to announce these present values or cash flows to the market, if we take a slightly less abstract view (although strictly in such reasoning this would automatically happen for markets to be perfect and complete). The value of the company would then equal the present value of these cash flows, which in turn would equal the market price. Under these circumstances one may even question whether annual reports are necessary. Within mainstream economic thinking (that assumes ‘perfect and complete markets’ to maximise well-being and the role of ‘accounting information’ to be confined to serving markets), the answer to this question would be in the negative as it would be to the question ‘is the regulation of accounting necessary in this context?’ The market here provides what is deemed an unambiguous and value free measure of wealth. Even in a broader, more holistic view, the argument might weigh against state and/or quasi-state regulation in this economic sphere where markets were more perfect and complete.

In any case, the scenario of perfect and complete markets does not reflect the real world. Markets are not complete and perfect and thus the market does not provide an unambiguous measure. So we can consider the case for state and/or quasi-state regulation within a mainstream economics perspective.

Other perspectives hold that the functioning of markets (within an institutional, regulatory framework) is enough to regulate financial accounting adequately. Businesses have an incentive to provide accounting information to the market to raise capital and an interest in being honest and providing good quality information due to the negative impacts of loss of reputation (organisations failing to inform or misleading the capital market will be regarded as ‘lemons’ – and punished). Another way of seeing this is that there are strong incentives for managers to disclose information, e.g. they may need to raise finance in the competitive market and will thus provide relevant information to aid them in this (and reputation has a value here so honesty may pay). In addition there is a market for managers, in so far as the managers themselves would want to inform the market as to how well they are doing and hence enable them to seek other jobs elsewhere. The ‘free market’ camp would thus argue that, even in the real world, we should leave it to the market or what some call ‘market regulation’ (noting that markets themselves always appear to require some form of state regulation in practice). Some argue the market for information is good enough to produce an optimal supply.

There are also contracting arguments that have been put forward. Companies could simply have a contract with their suppliers of capital to disclose certain information to them, including having the information audited. Any undisclosed information could then be obtained by private searches and/or payment for additional information that may be required.

One point that may be made here too is that regulation beyond the market may displace some of the positives of market functioning. It may problematically, for instance, restrict the accounting methods that may be used (although that may also reflect a poor form of interventionist


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regulation). Further, users will tend to overstate their desire for disclosure if they do not have to pay for it (although indirectly they may bear costs). The costs will be borne by those supplying the information.

History does indicate that companies will voluntarily disclose at least some information (at least they will disclose some information under other pressures). While those observing practice historically admit to some evidence of this type of market-induced effect, substantively they point to weak financial accounting here and the case for regulating financial accounting in terms of state and/or state-backed or quasi-state professional regulation, beyond the more liberal approach. The view here is that the market for information is such that without interventionist regulation a sub-optimal amount of information will be produced. And the comparability it facilitates may be less than desirable. The case for likewise regulating notions of broader corporate social responsibility accounting is similar. This said, contexts vary and a great deal of pressure may be placed on business (e.g. by competitive forces, a strong civil society) without legislation or quasi-law.

Under the contracting arguments, the actual cost of enforcing the individual contracts or ‘group contracts’ would be higher than those costs associated with state and/or state-like regulation. Even with these contracts there would be a need for comparability of accounting practices.

A number of related arguments for regulation have been suggested, reflecting the assumption of an imperfect markets context, including the following:

• Left unregulated as envisaged, market forces would ‘lead to an uneven possession of information among investors’. Consequently the regulation would provide an equitable solution. ‘It is only fair that the less informed be protected from the more informed.’ Some have more power than others (over others) in terms of accessing information.

• Accounting information shares the characteristics of a public good, and therefore suffers the same problems of externalities and free riders. Under these conditions the absence of the regulation envisaged could result in the under provision of information.

• Managers have incentives not to disclose unfavourable information. Consequently investors would be unable to distinguish good companies from bad ones, resulting in ‘adverse selection’. Further, investors need protection from the fraudulent, which would actually produce misleading information. Due to information asymmetries, the disclosures may not obviously be seen as fraudulent.

Others argue markets are not so speedy in re-adjusting to changes. If they may keep returning to reasonable positions or an equilibrium (a contestable view for some), people may get hurt in the process, given its slow speed. Indeed this may be in ways they can scarcely be compensated for.

The ‘balanced’ view on financial accounting discussed above may be taken as implying that regulation to improve transparency should not be universally overly strict, or it might imply the need for a regulation that has limits and that might be set so as to prevent firms competing in the market place in terms of information disclosure, which may drive disclosure towards too much transparency. In an imperfect markets context, a particular level of disclosure or transparency would be optimal for social welfare. A degree of secrecy or confidentiality is required


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to allow the system to function for the best (e.g. create incentives for research and development, discourage monopolistic practice that might be encouraged through information sharing). A degree of transparency is required to facilitate financing and the better allocation of resources. The regulation envisaged may bring this balanced disclosure about better. Markets functioning without that may lead to ‘beggar-my-neighbour’ disruptive forms of competition in respect of disclosure.

Some analysts of the issues have used game theory as a framework and tried to model (appreciating the possibility of audit) external financial accounting disclosures in relation to the incentives of regulators and corporate managers (e.g. incentives to disclose or hide, to be honest or dishonest). From this quasi-descriptive modelling (to which dimensions of uncertainty and the costliness of information can be built in) an attempt is made to see if answers can be found to questions such as: Is rigid regulation better than flexible regulation? Is mandatory disclosure better than a looser more voluntary approach? This framework can enhance appreciation of the character and feasibility of actual and potential regulatory forms, although it is not straightforward to translate this into social welfare implications in an imperfect markets and imperfect societal context.

Accounting standards: what form should they take?One way of regulating accounting, suggesting intervention beyond the more liberal approach, is through accounting standards. These could be prescribed by law or by ostensibly independent professional bodies (and the latter’s prescriptions may then in some way be backed by law).

If we believe in regulating accounting through the use of accounting standards, what form should the standards take? We could consider Edey (1977)’s discussion. Edey (1977) discussed and illustrated four possible types of accounting standards, all with different levels of detailed rules, with the lowest level (Type 1) being less prescriptive than the highest level (Type 4).

Type 1: ‘Tell people what you have done.’ This type of standard in the first place restricts accounting to information about what has happened but Edey emphasises that the restriction is to basic disclosure rules.

Type 2: Uniformity of presentation. This type of standard would only concern rules on how you should present your financial results and hence create some form of uniformity and consistency.

Type 3: Disclosure of specific matters. This type of standard would require disclosure of specific matters in certain cases.

Type 4: How to value assets/liabilities, what is regarded as income, how income is allocated to periods, and so on. Edey here characterises this type of standard as specifying considerable detail.

In terms of the earlier argumentation, the more detailed and the less flexible the requirements then the stronger the regulation.

Activity 1.1

Read Beaver (1981) Chapter 7 and Gallhofer and Haslam (2007), taking notes.

Critically appraise the main arguments that Beaver puts forward for increased regulation. How do Gallhofer and Haslam (2007) see accounting regulation?


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Comparing arguments for and against standards is clearly related, then, to arguments for and against forms of regulation. We extend or refine the earlier argumentation by considering Baxter. These reflect an understanding of the nature of company law in the UK context, whereby that law is assumed not to prescribe very detailed inflexible accounting standards.

Arguments for accounting standardsBaxter outlines the arguments for the imposition of accounting standards, suggesting that:

• standards provide handy rules for the daily work of accountants.

Types 1–3 in Edey’s typology would:

• help improve published reports

• supplement company law with fuller, clearer and more consistent figures

• foster comparability which in turn would help analysts and potential investors compare and evaluate firms

• force weaker accountants to improve their work

• provide a defence for accountants in court, and strengthen resistance ‘if a tycoon tries to bully his accountants into producing biased figures’.

Other arguments put forward include the following:

• They would provide credibility to the accounting profession which might otherwise be undermined if there are continued scandals over the extreme subjectivity of some companies’ financial statements.

• They provide discipline – although some believe that if companies were left to their own devices they would ultimately be disciplined by the financial markets.

• In the short term, the use of standards attempts to alleviate the risk to investors.

Arguments against accounting standardsThe following arguments have been made:

• Accounting standards are costly and bureaucratic.

• Accounting figures (due to their very nature) do not lend themselves to standardisation; industries differ, so do firms; the needs of users vary. Thus standards may be suitable for the average but may not suit the fringes.

• Standards can lead to a kind of rule following, where two similar situations might be treated differently becuase they fall either side of a rule.

• Standard-setters may bow to political pressures and thus the development of accounting standards may be merely consensus-seeking (e.g. accounting standards could be over-influenced by those parties with easiest access to the standard-setters or the most vocal lobbyist).

• Standards in themselves could actually reduce professional judgement and be bad for the academic education of accountants (e.g. they might be more interested in what is required to comply with the standard than in investigating the ideal accounting system).

• Standards may lull users into a false sense of security (i.e. investors may believe that the accounts are all based on the same specific rules,


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when in fact a standard principle may still leave room for different estimates). Consequently investors and other users need to be educated about this.

• If they do not take account of possible economic consequences, standards may result in adverse allocation effects. Accounting standards might result in sub-optimal behaviour purely to ensure that accounting earnings are not reduced.

• Standards could result in overload, e.g. if there are too many standards; if standards are too detailed; if standards are not specific enough; if there are too many standard-setters.

Descriptions of accounting and its regulationThere are various types of descriptive theory. They may be more or less subjective or subjectivist in their orientation. They may be developed from a quite precise theoretical proposition or hypothesis or from a much looser, open stance. All theories may be considered mixtures of the deductive and inductive (i.e. they are developed through a process of logical deduction from underlying premises and from reflection on observed reality) but they may have a deductive or an inductive emphasis. They can draw upon different understandings of context and have different themes. They may be more or less critical (i.e. their prescriptive dimension may imply a more or less radical position).

Deegan and Unerman (2011) provided an overview of different descriptive theories of financial accounting. Financial accounting may be understood in practice to equate to what it should be in a prescriptive theory or it could be understood as failing against its prescriptive benchmark. Deegan and Unerman (2011) point to theorists who suggest it is biased to serve the relatively rich and powerful in society. Others suggest that financial accounting may promote a materialist or narrow culture. For instance, they suggest that accounting portrays that a materialist profit making is the only thing important about a business organisation, which accounting constructs as a financial machine, and it encourages a simplistic dichotomous debit-credit kind of thinking in areas beyond technical accounting. In terms of accounting regulation, again this may be seen in a descriptive theory to equate with a prescriptive theory of accounting regulation as it should be. Other theories include capture theory – where those who are meant to be regulated control the regulations – and theories that, for example, suggest that accounting regulation is largely controlled by the relatively rich and powerful.

Many descriptive theories begin with an attempt to understand what accounting and accounting regulation are like in terms of basic content and form, e.g. what are the requirements of a law or standard? This is an emphasis in what follows. Many theories see actual regulatory developments as appropriately responding to regulatory failures (although these developments may be found wanting as things change – giving rise to new regulations also deemed appropriate). Such theories are very similar to those that equate actual practice to some variant of prescriptive theory. They may also be considered official theories as they are theories that official regulatory bodies would use to describe themselves.

Activity 1.2

What criteria are relevant in deciding upon accounting standards? Should standards specify the detail or be more in the nature of general guidelines?


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We focus here initially on accounting regulation in ways that substantively reflect such basic description and mainstream interpretation. We focus on accounting regulation in the UK but in the global context, reflecting the significant influence of international accounting standards in the UK (and beyond).

UK accounting regulation and the influence of international accounting standards

The regulatory framework relating to financial reporting varies from country to country. For Cooke and Parker (1994), the nature of the regulatory framework will depend upon (among other things):

• the influence of tax rules

• the type of legal system

• the history and influence of the accounting profession.

In the UK, the regulatory framework has developed over many years and consists of a mass of rules and regulations – some statutory, some mandatory, others customary. We shall consider the variety of rules and regulations that exist in the UK. Note that the UK regulatory framework has been influential in many other countries. For instance, Cooke and Parker (1994) state that:

Impetus for regulationOften, regulations are implemented after well-publicised scandals. This was the case with the establishment of the UK’s Accounting Standards Steering Committee (ASSC) in 1970. Two scandals in the late 1960s were understood to highlight the extent of subjectivity in financial reporting: the General Electric Corporation (GEC) takeover of AEI Ltd and Pergamon Press’s profit figure both led to questions about the correctness of published financial statements of UK companies. Even today, with the existence of standards that have over time tended to become more extensive and detailed, similar questions are asked, e.g. in the US following the scandal of Enron.

Institutional setting for accounting regulation: the UKThe rules applicable to large UK companies (rather than small or medium-sized ones) come in three main forms:

• Statutory legislation: primarily the Companies Act 1985 and the Companies Act 1989 (revised). The European Union (EU) instigated a harmonisation programme that involved the issuing of a number of directives in order to harmonise the accounting practices of companies within the EU. In November 1995 the EU announced: ‘Rather than amend existing Directives, the proposal is to improve the present situation by associating the EU with the efforts undertaken by IASC and IOSCO towards a broader international harmonisation of accounting standards.’ The EU adopted regulations with effect from 1 January 2005 that required listed companies in Europe to use generally accepted international accounting principles (IASs/IFRSs) when preparing their group accounts.

Malaysia’s colonial past is reflected in many ways in the current reporting environment, which is very similar, though not identical to the UK environment.


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• Mandatory regulation: the Statements of Standard Accounting Practice (SSAP) developed originally by the Accounting Standards Committee (ASC) and adopted by the Accounting Standards Board (ASB), and Financial Reporting Standards (FRSs) issued by the ASB since 1990.

• The Stock Exchange Listing Rules: these impose rules on companies listed on the London Stock Exchange, including compliance with the Combined Code of Corporate Governance (2003).

Statutory legislation: Companies Act

The Companies Acts prior to the early 1980s contained only general requirements for companies and groups relating to the need to prepare, distribute and file financial statements. There was very little detail in the Acts – this was left to the practices adopted by accountants.

In 1981 requirements about the form and content of published accounts underwent a radical change when the UK implemented the EC (now EU) Fourth Directive in the Companies Act 1981. The Fourth Directive imposed standardised formats for the income statement and balance sheet, and required a ‘true and fair view’1 (see below). This was achieved by making rules about:

• the format of accounts

• certain accounting principles

• valuation rules

• disclosure of information.

The Companies Act 1985 (CA 1985) consolidated the previous Acts (1947, 1948, 1967, 1980 and 1981) and set out general rules and formats governing the content and form of published company accounts.

CA 1985 was then amended and supplemented by the Companies Act 1989, which enacted the Seventh EU Directive. This Directive had a similar role to the Fourth, but in connection with consolidated accounts. Its objective again was to harmonise practice within the EU, but its effect in the UK was less dramatic than had been the case with the Fourth Directive, because the basis of the Seventh Directive was to a large extent the Anglo-Saxon model of consolidation, whereas the Fourth Directive had been based more on continental practices.

The ‘true and fair’ requirementIn addition to preparing accounts, s.226 of the 1985 requires that:

In the above respect, the Act makes it clear that the true and fair requirement is overriding.

1 The ‘true and fair view’ was required in the UK prior to the Fourth Directive. Indeed, it was as a result of the UK’s pressure upon the EU that the true and fair requirement was included in the Directive.

(2) The balance sheet shall give a true and fair view of the state of affairs of the company as at the end of the financial year; and the [income statement] shall give a true and fair view of the profit and loss of the company for the financial year.

(3) A company’s individual accounts shall comply with the provisions of Schedule 4 as to the form and content of the balance sheet and [income statement] and additional information to be provided by way of notes to the accounts.

If in special circumstances compliance with any of those provisions is inconsistent with the requirement to give a true and fair view, the directors shall depart from that provision to the extent necessary to give a true and fair view. Particulars of any


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What is the definition of ‘true and fair’?The Companies Act does not define ‘true and fair’. However, within the Financial accounting literature, Lewis and Pendrill (2004, p.27) quote a definition by G.A. Lee (1981, p.270):

Statutory regulation: IASs/IFRSs gained force of lawThe International Accounting Standards Board (IASB) was preceded by the Board of the International Accounting Standards Committee (IASC), which operated from 1973 until 2001. The IASC gained the acceptance of the International Federation of Accountants, a worldwide association of accountancy bodies with the aim of harmonising accounting standards at an international level. The IASC was (as the IASB is) a private sector body ostensibly independent of government influence. The level of harmonisation achieved was understood to be reduced by (a) weak standards that permitted too many accounting choices in order to satisfy diverse member requirements and (b) a lack of enforcement power. Enforcement was eventually achieved via the International Organization of Securities Commissions (IOSCO) (see stock exchange regulation below) and the EU. In 1995 the EU agreed to require all listed European companies to conform to IASs/IFRSs, following a review of the standards. The following year the EU Contact Committee reported that IASs/IFRSs were compatible with EU directives, with minor exceptions, leading to legislation in 2001 that required all EU listed companies to follow IASs/IFRSs from 2005. Hence, IASs/IFRSs constituted statutory regulation for the listed companies. The IASB superseded the IASC in 2001, inheriting 34 standards, 14 of which were criticised by the IOSCO as unacceptable by regulators worldwide. The IASB was set up initially recognising the IASs but gradually replacing them and adding to them with IFRSs. The IASB decided to improve the standards before the EU adoption in 2005, and thereby embarked on the improvements project. This project was completed by 2003, resulting in 15 revised IASs (IFRSs). From 2005 Australian-listed groups and from 2007 New Zealand-listed groups had to comply with IASs/IFRSs. More recently South Korea, China, Brazil, Israel, Malaysia and Mexico have made similar moves or committed to the same. Several countries have domestic GAAP identical to the IASs/IFRSs and some have abandoned developing their own standards. FASB and IASB are committed to a convergence process and progress on this has been made.

such departure, the reasons for it and its effect shall be given in the note to the accounts. (Section 226(5))

Today ‘true and fair’ has become a term of art. It is generally understood to mean a presentation of accounts, drawn up according to accepted accounting principles, using accurate figures as far as possible, and reasonable estimates otherwise; and arranging them so as to show, within the limits of current accounting practice, as objective a picture as possible, free from wilful bias, distortion, manipulation or concealment of material facts.


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Mandatory regulation: standard-setting and the case of the UK

In the UK, prior to the establishment of the Accounting Standards Committee (ASC), legislated accounting regulation was limited to a few statutory rules governing the presentation of financial statements within the Companies Act. These were very basic and accounting practices were varied and inconsistent. Consequently the ASC was set up in 1976. Its objectives were to:

The ASC’s membership consisted of representatives from the various UK accounting bodies. They were part-time and unpaid. Following major criticism of the ASC that it was unable to respond quickly to changing needs or to deal with fundamental issues, a Review Committee was established in 1987 under the chairmanship of Sir Ronald Dearing.

Following the Dearing Report on the creation of accounting standards, the following bodies were established:

FRC Ltd Board

Executive

Council

Committee onCorporate

Governance

AccountingStandards

Board

UrgentIssues

Task Force

AuditingPractices

Board

Board forActuarial

Standards

ProfessionalOversight

Board

FinancialReporting

Review Panel

AccountancyInvestigation

and DisciplineBoard

Figure 1.1 Organisational chart for the accounting standard-setting body in the UK. Source: www.frc.org.uk/about/chart.cfm

• Financial Reporting Council (FRC) Established in 1990, this is made up of representatives of users, preparers and accountants in practice. It provides guidance to the Accounting Standards Board (ASB) on work programmes, priorities and issues of concern, and is responsible for financing arrangements. The chairman is appointed by the Secretary of State for Business, Enterprise and Regulatory Reform with the Governor of the Bank of England, the accountancy profession and the financial community. The FRC is financed by the government, the accountancy profession and financial institutions (the government contributing about one-third against the two-thirds from the accountancy profession and financial institutions respectively). The FRC aims ‘to promote confidence in corporate reporting and governance’.

• Financial Reporting Review Panel (FRRP) Established in 1990 with a QC as its Chair, the FRRP examines material departures from standards by large companies. The Introduction to Accounting Standards requires it to:

define accounting concepts, to narrow differences of financial accounting and reporting treatment, and to codify generally accepted best practice in the public interest.

enquire into annual accounts where it appears that Companies Act requirements, including the


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It has been authorised under the Companies Act to make application to the court for a declaration that a company’s annual accounts do not comply with the requirements of the Companies Act and for an order that the directors prepare revised accounts. (See below.)

• Accounting Standards Board (ASB) Established in August 1990, this replaced the ASC. It is an expert body to develop, issue and withdraw accounting standards, with a full-time chairman and technical director and 10 members in total (originally nine). It also has a large full-time secretariat. It issues Financial Reporting Standards (FRS) on its own authority, on a two-thirds majority. A committee of the FRC appoints its members.

The ASB has stated its aims as follows:

One of the ways in which it intends to achieve its aims is by ‘developing principles to guide it in establishing standards and to provide a framework within which others can exercise judgement in resolving accounting issues.’

It has listed a number of ‘fundamental guidelines’ which include ‘to be objective and to ensure that the information resulting from the application of accounting standards faithfully represents the underlying commercial activity’; such information should be ‘neutral in the sense that it is free from any form of bias intended to influence users in a particular direction and should not be designed to favour any group of users or preparers.’

Other fundamental guidelines include issuing standards only when the expected benefits exceed the perceived costs, and ‘taking account of the desire of the financial community for evolutionary rather than revolutionary change in the reporting process where this is consistent with the objectives.’

• Urgent Issues Task Force (UITF) This is concerned with serious differences in current practice. Its main role is to assist the ASB in areas where an accounting standard or Companies Act provision exists but where unsatisfactory or conflicting interpretations have arisen or seem likely to develop. It reaches a consensus about issues and its pronouncements are published in Abstracts, available on the FRC website.

Accounting standards and company lawFollowing the Dearing Committee’s review of standard-setting, changes were also made to company law:

• Section 19 of the Companies Act 1989 inserted a new section (s.256) into CA 1985. This includes a definition of accounting standards and, among other things, gives the Secretary of State power to make grants to bodies (or for the purpose of):

issuing accounting standards overseeing and directing their issue

investigating departures from standards or from the accounting requirements of the Act and taking steps to secure compliance with them.

requirement that annual accounts shall show a true and fair view, might have been breached.

to establish and improve standards of financial accounting and reporting, for the benefit of users, preparers and auditors of financial information.


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• The Companies Act 1989 inserted a new paragraph 36A into Schedule 4 of CA 1985. This requires it to be stated whether the accounts have been prepared in accordance with applicable accounting standards, with particulars of any material departure from those standards and reasons for these to be given.

• Section 12 of the Companies Act 1989 inserted a new section (s.254B) into CA 1985 giving the Secretary of State power to apply to the court for a declaration that a company’s annual accounts do not comply with the requirements of the Act and for an order that the directors prepare revised accounts. The Secretary of State may also authorise a person for this purpose and, as noted above, has authorised the Financial Reporting Review Panel (FRRP) to make such applications. If the court finds against the company, it may order that application costs and reasonable expenses of the company in connection with (or in consequence of) preparing revised accounts shall be borne by the directors who were party to approving the defective accounts.

Note that the power to apply to the courts relates to non-compliance with the Act’s requirements rather than specifically with standards. This then raises the question of the relationship between accounting standards and the requirement for accounts to show a true and fair view. Below is the professional opinion of Mary Arden QC:

Mary Arden QC stated that whether accounts satisfy true and fair requirements is for the courts to decide, but they will look to the practices and views of accountants; the more authoritative these are, the more the courts will be ready to follow them.

The Companies Act 2006 implemented some of the proposals of the Company Law Review (see Activity 1.4).

Stock ExchangeThe London Stock Exchange also lays down regulations concerning listed companies’ published accounts. The regulations require the provision of more information, and more frequently, than either the law or the UK ASB or the IASB requires. For example, companies are required to publish interim accounts and provide more detail regarding certain liabilities (e.g. bank loans).

In 1995 the International Organization of Securities Commissions (IOSCO) agreed to a review of IASs, with a view to endorsing IASs for cross-border

Compliance with accounting standards will normally be necessary for Financial Statements to give a true and fair view… The requirement to give a true and fair view may in special circumstances require a departure from accounting standards… If in exceptional circumstances compliance with an accounting standard is inconsistent with the requirement to give a true and fair view, the requirement of the accounting standard should be departed from to the extent necessary to give a true and fair view. (Appendix to Foreword to Accounting Standards, ASB, 1993)

Just as a custom which is upheld by the courts may properly be regarded as a source of law, so too, in my view, does an accounting standard which the court holds must be complied with to meet the true and fair requirement become, in cases where it is applicable, a source of law in itself in the widest sense of that term. (Mary Arden QC, ‘The True and Fair requirement’.)


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offerings. Fourteen standards were rejected by IOSCO but later revised by the IASB. The IOSCO’s technical committee now ‘recommends that its members allow multinational issuers to use IFRSs in cross-border offerings and listings, as supplemented by reconciliation, disclosure and interpretation where necessary to address outstanding substantive issues at a national or regional level’ (Technical Committee of IOSCO, Statement on the development and use of International Financial Reporting Standards in 2005, February 2005, p.4).

UK listed companies must also comply with the Combined Code of Corporate governance (Higgs, 2003). The Combined Code provides general guidance on governance and internal control for organisations. Corporate Governance has come under great scrutiny following a string of high-profile corporate collapses such as Enron and WorldCom, associated with fraud, abuse of managerial power and social irresponsibility. This triggered a number of accelerated reviews of governance frameworks and resulted in an increased number of practical pronouncements. In the USA the Sarbanes-Oxley Act on corporate governance is the most comprehensive law to affect accounting and the audit profession since the Securities and Exchange Act 1934. By changing guidelines into formal law, this represents a divergence from the UK model on corporate governance (Friedman and Miles, 2006, p.258)

Reminder of learning outcomesHaving completed this chapter, and the Essential reading and activities, you should be able to:

• delineate the basic character of financial accounting theory

• discuss the role of accounting in society

• explain the different levels of authority in the UK regulatory framework

• explain and discuss the implications of the International Accounting Standards Board on the role of the Accounting Standards Board

• discuss the arguments for and against accounting standards

• discuss the theory of regulation

Activity 1.3

In the UK, the Stock Exchange was one of the earliest sources of rules and regulations relating to financial statements. In many other countries, the rules and regulations of the relevant stock exchange are important.

a. Why do stock exchanges take such an interest in rules and regulations relating to financial statements?

b. What are the main requirements of the stock exchange in your country?

Activity 1.4

The Company Law Review was set up to examine the whole framework of company law. Study its recommendations: Company Law Reform. Modern Company Law for a Competitive Economy: Developing the Framework, which can be found at: www.berr.gov.uk/files/file23245.pdf.

A Companies Act was introduced in 2006. To what extent did it implement the recommendations?

http://www.berr.gov.uk/files/file23245.pdf


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Sample examination questions

Question 1.1To what extent should accounting standards take economic consequences into account? Discuss.

Question 1.2What factors should be considered in deciding upon the form of accounting regulation?


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Notes

Chapter 2: Conceptual framework

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Aims of the chapterThe aim of this chapter is to consider what a conceptual framework is and then to address some of the key principles related to setting up a conceptual framework. These principles have been examined by many different groups of standard-setters around the world (including in Australia, Canada, the UK and the USA). We will look at the UK’s Statement of Principles (SOP) and the US Concept Statements. The ASB modelled the SOP on the IASB Framework for the Preparation and Presentation of Financial Statements (FPPFS), which in turn was based on the US conceptual framework. It is strongly recommended that you review the FPPFS.1

Learning outcomesBy the end of this chapter, and having completed the Essential readings and activities, you should be able to:

• define a conceptual framework

• identify the main efforts by the US, the IASC and the UK to introduce a conceptual framework

• describe the objectives of financial reporting as per the conceptual frameworks produced

• explain the ‘ideal’ qualitative characteristics of accounting information as suggested by these frameworks

• define assets and liabilities as suggested by these frameworks

• explain and describe recognition and measurement

• apply the conceptual frameworks to particular transactions; for instance, would they help in deciding how to account for research and development?

Essential readingInternational Financial Reporting, Chapter 8. Accounting Standards Board, 1999, Statement of Principles for Financial

Reporting. (Reproduced in Accountancy, March 2000, pp.109–38). See below for the ASB website.

WebsitesSee also the following websites:

www.frc.org.uk/asb/technical/principles.cfmwww.iasb.org.uk/ then follow links to summaries of international financial

reporting standards

Further readingBromwich, M. Financial Reporting, Information and Capital Markets. (London:

Pitman Publishing, 1992) [ISBN 9780273034643]. Chapter 12 (Although this focuses specifically on the FASB’s conceptual framework, it also discusses a number of issues about the conceptual framework approach that can be considered in relation to the IASB’s FPPFS and the ASB’s Statement of Principles.)

1 To find this, consult the IASB website: www.iasb.org.uk/

http://www.frc.org.uk/asb/technical/principles.cfm

http://www.iasb.org.uk/

http://www.iasb.org.uk/


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Ernst and Young, International GAAP 2012: Generally Accepted Accounting Practices under International Reporting Standards. (Chichester: John Wiley & Sons, 2012) [ISBN 9781119962458]. Chapter 2.

Lewis, R. and D. Pendrill Advanced Financial Accounting. (Harlow: Financial Times Prentice Hall, 2004) seventh edition [ISBN 9780273658498]. Chapter 1.

Macve, R. A Conceptual Framework For Financial Accounting and Reporting: the Possibilities for an Agreed Structure. (London: Institute of Chartered Accountants in England and Wales, 1981) [ISBN 9780852913116].

Relevant IASB publicationFramework for the Preparation and Presentation of Financial Statements.

Relevant UK standardsThe Statement of Principles.FRS 18 Accounting Policies (replaced SSAP 2 Disclosure of Accounting Policies).

Definition of a conceptual frameworkThe quest for a conceptual framework for financial reporting has been undertaken (with varying degrees of success in terms of securing agreement) in many different countries. But what is a conceptual framework?

In the USA, one definition by the Financial Accounting Standards Board (FASB) is:

The ASB in the UK states that their Statement of Principles (SOP) (equivalent to the US conceptual framework):

Macve (1981) stated that a conceptual framework would:

However, he also recognised that it would be difficult to implement such a conceptual framework.

All three definitions suggest that a conceptual framework provides an explicit description of how accounting rules should be formulated and the environment in which they apply. More specifically, a conceptual framework is supposed to address some fairly fundamental questions about financial statements themselves. For instance:

• What are the objectives of financial statements?

• For whom and by whom are these financial statements required?

• What information do the users of these financial statements require?

• What types of financial statement would best satisfy these users’ needs?

• Do current financial statements meet these requirements?

• How could current financial statements be improved?

A Conceptual framework is a constitution, a coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function and limits of financial accounting and financial statements.

sets out the principles that the Accounting Standards Board believes should underlie the preparation and presentation of general purpose financial statements… A coherent frame of reference to be used by the Board in the development and review of accounting standards.

provide a consistent approach for making decisions about choices of accounting practice and for setting standards.


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Although these questions are fundamental, the extent to which they have been addressed varies among countries. However, in general:

In other words, too often standard-setting is reactive (to particular problems) rather than proactive.

Rationale for a conceptual frameworkThe FASB states that the rationale for a conceptual framework is:

1. To facilitate decisions on controversial accounting issues – providing a clear basis for reaching conclusions that those with vested interests would find it hard to resist.

2. To provide a common framework of reference on theoretical issues, so as to avoid both waste of effort in addressing such issues from first principles for each specific standard and the dangers of inconsistency.

3. To reduce the need for many detailed standards on specific issues – by enabling accountants to resolve issues by reference to general principles rather than detailed rules.

Advantages claimed for a conceptual frameworkAccording to the UK Statement of Principles, a conceptual framework should:

• clarify the conceptual underpinnings of proposed accounting standards

• enable standards to be developed on a consistent basis

• reduce the need to debate fundamental issues each time a standard is developed or revised

• enable preparers and users of financial statements to understand the Board’s approach to setting standards and the nature and function of information in general purpose financial statements

• help preparers and auditors with new issues to carry out an initial analysis of the issues in the absence of applicable accounting standards.

Other advantages claimed for a conceptual framework are that it:

• facilitates decisions on controversial items, by reducing the scope for personal bias and political pressure

• may reduce the need for many detailed standards if accountants can resolve issues by general principles

• limits the bounds of judgement and hence increases comparability

• may protect accounting from intervention by governments

• helps justify accounting practices when they are under attack in the courts, if they can be shown to be derived from, and consistent with, a conceptual framework.

the various standard-setting bodies around the world have too often attempted to resolve practical accounting and reporting through the development of accounting standards, without such an accepted theoretical frame of reference. (Ernst and Young, 2001)


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The US, IASC and UK initiatives comparedIn this section we consider briefly some of the important milestones in the quest for a conceptual framework in the US, IASB and the UK. You need not know the exact detail as such, but you should be aware of the main considerations of each initiative and the main similarities and differences between each approach.

US initiative: FASB conceptual frameworkThe FASB issued six concept statements in the late 1970s/early 1980s, of which five are listed here:

• Statement of Financial Accounting Concepts (SFAC) No. 1 Objectives of Financial Reporting by Business Enterprises.

• SFAC No. 2 Qualitative Characteristics of Accounting Information.

• SFAC No. 4 Objectives of Financial Reporting by Non Business Organisations.

• SFAC No. 5 Recognition and Measurement in Financial Statements of Business Enterprises.

• SFAC No. 6 Elements of Financial Statements (replacing SFAC No. 3).

• SFAC No. 7 Using Cash Flow Information and Present Value in Accounting Measurements.

This chapter will discuss four of these concept statements – 1, 2, 5 and 6 – which address some of the key conceptual issues.

IASC Framework for the presentation and preparation of financial statements

The IASC conceptual framework was introduced as an exposure draft in May 1988, and a final statement in September 1989, in an attempt to ‘explain the conceptual framework that underlies the preparation and presentation of financial statements.’ Apparently modelled on the FASB framework, it exhibits many of the strengths and weaknesses of that earlier framework (see discussions below).

UK: ASB’s Statement of Principles (SOP)In the UK the ASB issued a Draft Statement of Principles, initially chapter by chapter but then as a whole, for general comment. In 1996, some aspects of the Draft Statement of Principles attracted adverse comment and as a result this framework was modified. The final version of the SOP was agreed in October 1999. Appendix II notes that the SOP was based on the IASC’s Framework. Appendix III points out that the Board does not regard the SOP as the final word on the principles underlying financial reporting and that, as accounting thought is continually evolving, it may need to be revised from time to time. Currently the SOP consists of eight chapters:

Chapter 1: The Objective of Financial Statements

Chapter 2: The Reporting Entity

Chapter 3: The Qualitative Characteristics of Financial Information

Chapter 4: The Elements of Financial Statements

Chapter 5: Recognition in Financial Statements

Chapter 6: Measurement in Financial Statements

Chapter 7: Presentation of Financial Information

Chapter 8: Accounting for Interests in Other Entities.


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Although the main purpose of the SOP is to help set accounting standards, the Introduction to it notes that, due to other factors to be considered when setting standards (including legal requirements and cost/benefit considerations), a standard may still adopt an approach different from that suggested by the principles. The SOP has not been developed within the constraints imposed by company law so it may contribute to the future development of law.

Objectives of financial reportingThe underlying objective of all the conceptual frameworks discussed above in relation to financial reporting is to provide useful information so users can make business and economic decisions. This is sometimes contrasted with an alternative objective – to provide information on how the business has carried out its stewardship responsibilities.

There is an overlap, however, between these objectives. One may argue that information about historical stewardship, or accountability for past actions, is relevant for decision making and control and indeed the rationale for it may be expressed in these terms. Nevertheless the objective promoted in the conceptual frameworks is not as restricted. In principle, it goes beyond history, stewardship and accountability without limit. This freedom results in threats as well as opportunities for and through accounting.

Decision usefulness appears to be a reasonable objective, although we have seen that it should be subject to our discussion in the last chapter of context and the imperfect nature thereof. To satisfy it two questions should be considered:

1. Who are the users?

2. What type of information do they need?

In the case of the FASB, the statement identifies many potential users of accounts and their interests, but argues that those most directly concerned with a business share a common interest in the company’s ability to generate favourable cash flows. In developing objectives for general-purpose external financial reports, the statement focuses on the needs of investors and creditors (though it suggests that information prepared to meet these needs is likely to be generally useful to other groups which have essentially the same interest) and argues that:

Its principal conclusion is:

The SOP requires that financial reports provide information about:

• the economic resources of an enterprise, its obligations and owners’ equity

• enterprise performance and earnings

• liquidity, solvency and funds flow

• management stewardship and performance.

Financial reporting should provide information that is useful to present and potential investors, creditors and other users in making rational investment, credit and similar decisions.

Financial reporting should provide information to help investors, creditors and others assess the amounts, timing and uncertainty of prospective net cash flows to the related enterprise.


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It notes in relation to its requirement for information about enterprise performance that:

The FASB then asserts that what investors want are balance sheets and income statements: inductively from the fact that this is what they currently actually get and politically because the FASB has no intention of undermining the very basis of present practice and thus has rationalised accrual accounting.

However, the FASB has actually steered away from trying to identify the kind of information that may assist users (e.g. current value information, management forecasts, etc.)

In the UK, the ASB’s SOP states that the objective is to provide information about the financial performance and financial position of an entity which would be useful to a wide range of users in assessing the stewardship of managers.

The ASB has selected the investor’s perspective as the one most likely to help in the preparation of general-purpose financial statements. It states that, whilst recognising a large number of potential users of financial statements, who usually require different information for the different decisions they must make, a statement based on such a perspective focuses on the common interest of all users – the entity’s cash-generating ability and financial adaptability. It therefore focuses on present and potential investors as the defining class of user, arguing that in meeting their needs financial statements will meet the common needs of other users. It notes that information that is not needed by investors need not be given in the financial statements.

The SOP details the information required by investors, which is very similar to the FASB, and is said to comprise the following:

• In relation to financial performance: the return obtained on its resources, the components of that return and the characteristics of those components.

• In relation to financial position: the economic resources controlled by the entity, its financial structure, liquidity and solvency, risk profile and risk management approach, and capacity to adapt to changes in the environment.

• Information about the generation and use of cash, which provides a further perspective on financial performance.

Outside commentators on the objectives of reporting delineated in conceptual frameworks:

Many practitioners and academics have commented on the above approaches. For example, Bromwich (1992) pointed out that in the FASB’s Conceptual Framework the emphasis was strongly on information for decision-making. The same is true of the ASB Statement of Principles. Depending on how information for decision making is understood and how stewardship is understood, it is possible that information useful for decision-making purposes may not be useful for assessing stewardship.

…interest in an enterprise’s cash flows and its ability to generate favourable cash flows leads primarily to an interest in information about its earnings rather than information directly about its cash flows… Information about enterprise earnings and its components measured by accrual accounting generally provides a better indication of enterprise performance than information about current cash receipts and payments.


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The ASB defines stewardship broadly so as to include accountability not only for the safekeeping of the resources, but also for their proper, efficient and profitable use. It therefore involves an economic decision on whether (for example) to hold or sell shares and to reappoint or dismiss the management. Some would take a narrower view of stewardship and the information deemed useful by the ASB may not stretch to this specific.

Similarly, by focusing on the assumed common need, does the FASB ignore the possibility of differing (and possibly conflicting) needs of different users? In focusing in particular on investors and creditors, many other groups could be harmed by standards promulgated to meet the needs of these particular groups. This is the ‘social choice’ problem.

As Macve (1981) stated:

Qualitative characteristics of accounting informationAlthough most conceptual frameworks identify many of the same qualitative characteristics of accounting information, the hierarchy of these characteristics might vary. The overriding concern is that the information that is provided to users should be useful in relation to their decision-making process. To ensure that it is useful, this information should have certain characteristics. The characteristics considered here are:

• relevance

• reliability

• comparability

• understandability.

The FASB, in SFAC 2 Qualitative Characteristics of Accounting Infornation, examines the characteristics that make accounting information useful. It establishes a ‘hierarchy of accounting qualities’ (see Figure 2.1).

[R]ecognition of the variety of users’ needs and of conflicts between different rights leads to the view that reaching agreement on the form and content of financial statements is as much a ‘political’ process, a search for compromise between different parties, as it is a search for the methods which are ‘technically’ best.

Activity 2.1

Do you think that the investor’s perspective is the most appropriate?

With reference to a selected ‘conceptual framework’, satisfy yourself that you are aware of the range of stated objectives of financial reporting.


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Decision makersand their characteristics

Users of accountinginformation

Pervasiveconstraint

User-specificqualities

Primarydecision-specificqualities

Ingredientsof primaryqualities

Secondary andinteractivequalities

Threshold forrecognition

Benefit > Cost

Decision usefulness

Predictivevalue

Feedbackvalue

Timeliness Verifiability

Neutrality

Materiality

Representationalfaithfulness

Understandability

Comparability(including consistency)

Relevance Reliability

Figure 2.1 FASB’s hierarchy of accounting qualities

Similarly the ASB, in Chapter 3 of the SOP, sets out the qualitative characteristics of useful financial information in a diagram which is more detailed than the FASB’s but based on the same characteristics discussed above (see Figure 2.2).

What makes financial information useful?

Threshold quality MATERIALITY

RELEVANCE RELIABILITY COMPARABILITY UNDERSTANDABILITY

Giving information that is not material may impair the usefulness

of the other information given

Information thathas the ability to

influence decisions

Predictivevalue

Confirmatoryvalue

Faithfulrepresentation

Neutral Free from

material error

Complete Prudence Consistency Disclosure User’sabilities

Aggregationand

classification

Information that is acomplete and faithful

representation

Similarities and differences can be

discerned and evaluated

The significance of theinformation can be

perceived

Figure 2.2 ASB’s qualitative characteristics of useful financial information

The various terms used in the two figures are discussed below.

MaterialityTo begin with there must be some assessment of whether the information is material (i.e. could this information influence users’ decisions?). Materiality is viewed as a threshold characteristic because if any information is immaterial then users are not interested in it whatever other characteristics it has. Immaterial information should not be given as this may impair understanding of the financial statements. But what is material? Does the assessment of materiality vary between users?


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RelevanceThe FASB defines relevance as the capacity of information to make a difference in a decision by helping users to form predictions about the outcomes of past, present and future events to confirm or correct prior expectations. Similarly the ASB defines relevant information as that which is able to ‘influence the economic decisions of users and is provided in time to influence those decisions.’

Reliability The ASB states that reliable information is:

• faithful representation (i.e. it can be depended upon to represent what it purports to represent or could reasonably be expected to represent – reflects the substance of a transaction or event)

• free from deliberate or systematic bias (i.e. is neutral)

• complete and free from material error

• prepared on a prudent basis (i.e. under conditions of uncertainty, a degree of caution has been exercised in making the necessary judgements or estimates).

The FASB states:

ComparabilityThe ASB states that comparability enables users to discern similarities in and differences between the effect and nature of transactions and events between entities, and over time for the same entity (very similar to the FASB definition). It requires consistency and disclosure of accounting policies. The SOP notes, however, that consistency should not prevent the introduction of improved accounting policies.

UnderstandabilityTo be useful, information must be understandable. This depends on the way in which it is aggregated, classified and presented, and on the ability of users (who are presumed to have reasonable knowledge of business and accounting and are prepared to study the information with reasonable diligence).

Conservatism/prudenceIn the FASB hierarchy of accounting qualities, conservatism does not appear within the diagram, unlike prudence for the ASB. The FASB statement notes that there is a place for conservatism in financial reporting, but that if it is not applied with care it may conflict with qualitative characteristics such as neutrality and representational faithfulness by introducing bias. Conservatism should not imply deliberate, consistent understatement of profit and net assets; rather it requires that adequate consideration be given to the risks and uncertainty attached to business situations. Similarly the ASB states that prudence is only necessary in conditions of uncertainty and should not be used for deliberate overstatement of liabilities/losses or deliberate understatement of assets/gains, nor to create excessive provisions or hidden reserves.

To be reliable, financial statements must portray the important relationships of the firm itself. Information is reliable if it is verifiable and neutral and if users can depend on it to represent that which it is intended to represent.


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Trade-off between relevance and reliabilityBoth statements highlight the trade-offs that have to be made between relevance and reliability. The ASB states that where there is conflict ‘it will usually be appropriate to use the information that is the most relevant of whichever information is reliable’. However, financial information should not be provided until it is reliable. But how is one to assess which is ‘most relevant’? What if, for example, one method has greater predictive value but another greater confirmatory value? Neither statement helps the reader to determine how to make these trade-offs. What if different users have different preferences? Bromwich (1992) points to the problem of identifying characteristics for accounting information which are utility- or value-free.

Further comments Does spelling out what is meant by ‘useful’ get us very far? For Macve (1981): ‘many other studies have identified desirable attributes but have not led to greater agreement in practice about particular problems and it shifts the area of disagreement from ‘is this information useful?’ to ‘is this reliable?’ or ‘is this relevant?’ and may merely lead to ‘wordshuffling’. But the analysis may help us identify some reasons for disagreement (e.g. ‘this proposed treatment does not have predictive value/confirmatory value/faithful representation’).

It has been suggested that the definition of ‘reliable’ is circular: information is reliable if it can be depended upon to represent what it purports to represent (i.e. it is reliable if it is reliable).

Bromwich (1992) points to two problems with the use of predictive value in the FASB conceptual framework projects:

It has not made explicit the decision model it sees investors using.

It has not shown how accounting information can obtain predictive value.

Elements of financial statementsBoth the ASB and the FASB identify and define elements of financial statements which comprise the building blocks with which financial statements are constructed. The FASB defines 10 interrelated elements whereas the ASB defines only seven.

Activity 2.2

1. Often an accounting standard will have to make a trade-off between reliability and relevance:

a. What is the difference between reliability and relevance?

b. How should accounting standards rank these two qualitative characteristics?

c. Which user groups need to be considered when determining the relative importance of reliability and relevance?

2. Other qualitative characteristics might be important. Discuss how timeliness, objectivity, verifiability and neutrality might fit in with characteristics we have described already.

3. The benefits from reporting accounting information should exceed the costs. How easy (or difficult) do you think it is to quantify the costs and benefits of an accounting item?


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Definition FASB ASB

Assets √ √

Liabilities √ √

Ownership interest (equity) √ √

Gains √ √

Losses √ √

Contributions (investment) from owners √ √

Distributions from owners √ √

Comprehensive income √

Expenses √

Revenues √

Central to these definitions are the definitions of assets and liabilities. The ASB defines:

• assets as ‘rights or other access to future economic benefits controlled by an entity as a result of past transactions or events’, and

• liabilities as ‘obligations of an entity to transfer economic benefits as a result of past transactions or events.’

Although the definition of an asset covers most non-monetary assets found in the balance sheet, it does not necessarily cover all assets, such as certain intangible assets such as client lists. The use of the word ‘rights’ does not restrict the definition to an ownership criterion (consider finance leases).2 In particular, the statements point out that just because a transaction or event affects an element (e.g. results in the creation of a new asset), this does not mean that the effect will be recognised in the financial statements; that depends on the recognition and measurement criteria (discussed below).

In addition, ownership interest is defined as ‘the residual amount found by deducting all of the entity’s liabilities from all of the entity’s assets.’

The ASB definitions are practically identical to the FASB’s definitions.

The FASB statement points out the essential characteristics of assets and liabilities:

2 See Chapter 7.

An asset has three essential characteristics:

a. it embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash flows,

b. a particular entity can obtain the benefit and control others’ access to it, and

c. the transaction or other event giving rise to the entity’s right to or control of the benefit has already occurred.

A liability has three essential characteristics:

a. it embodies a present duty or responsibility to one or more other entities that entails settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand

b. the duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice, and

c. the transaction or other event obligating the entity has already happened.


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The ASB makes further points in relation to assets and liabilities:

In relation to assets it notes that:

• An asset is not the item of property itself but the rights or other access to some or all of the future economic benefits derived from it.

• There need not be legal ownership of the property from which the future benefits are derived.

• There need not be legal rights to future benefits.

• The future economic benefits need not be certain (though uncertainty may affect recognition).

• Entity control involves power to obtain for itself any economic benefits that arise and to prevent or limit others’ access to those benefits; the SOP notes that ‘it is generally not possible for an entity to choose if and when to realise the economic benefits derivable from factors such as its market share, superior management or good labour relations because the rights or other access to such benefits cannot be controlled independently of the business as a whole.’

• Control need not be legally enforceable.

In relation to liabilities the ASB notes that:

• ‘Obligations’ implies that the entity cannot avoid the outflow of resources.

• Legal obligation is not necessary (for example an obligation may be created by a pattern of past practice).

• It need not be certain that there will be a transfer of future economic benefits, only that there might be such a transfer; obligations that may not result in such a transfer will still be obligations, but may not be recognised in the financial statements.

• The obligation need not be to transfer known amounts of cash, it could involve, for example, the provision of services.

Further commentsAre the definitions useful, given that they are sufficient but not necessary conditions for the inclusion of an item in the financial statements? Macve (1981) points out that the definitions are so general that they are unlikely to exclude anything that one might reasonably want to include. Indeed, the FASB statement itself points out that it expects most assets and liabilities in the present practice to continue to qualify as assets or liabilities under the definitions, and that the definitions neither require nor presage upheavals in present practice.

Note that these definitions do not depend on legal enforceability. But how far removed from a legal one might a right or claim be? Is it a question of the probability of future benefits or sacrifice of future benefits? But how probable is probable? (The FASB statement notes that probable is used with its ‘usual general meaning’, referring to ‘that which can reasonably be expected or believed on the basis of available evidence or logic but is neither certain nor proved.’) What is a past transaction? What gives rise to the existence of an asset or liability?

These are some of the recognition problems that the statements do not help with, but which are particularly important for executory contracts3 – that is, a promise for a promise, for example an agreement to sell goods at a future date in return for payment at a future date. The ‘Elements’ chapter in the ASB statement says that rights and obligations

3 See below for further discussion.


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under such unperformed contracts represent a single asset or liability (‘a net position comprising a combined right and obligation either to participate in the exchange or alternatively to be compensated (or to compensate) for the consequences of the exchange not taking place’), and initially the rights and obligations are likely to be exactly offsetting, though often that will not remain the case. In the chapter on ‘Recognition’, the ASB notes that changing circumstances may cause an imbalance to arise, in which case the net position will either be an asset or a liability and will be recognised if the recognition criteria are met. It states, however, that where such an asset or liability exists, if the historical cost basis of measurement is being used, the carrying value will be the cost of entering into the agreement, which is usually nil. In effect the contract is recognised at nil.

Macve concludes that it is difficult to understand why the FASB should think these definitions helpful in analysing and resolving new accounting issues as they arise.

Recognition and measurement in financial statements SFAC 5, SOP4

RecognitionRecognition deals with those items that should appear in the financial statements. The ASB states:

The criteria for initial recognition of an element5 in the SOP are that:

1. There is sufficient evidence that the change in assets or liabilities inherent in the element has occurred (including, as appropriate, evidence that a future beneficial inflow or outflow will occur).

2. The element can be measured as a monetary amount with sufficient reliability.

Similarly the FASB sets out four fundamental recognition criteria:

1. meeting the definition of an element

2. measurability – having a relevant attribute which is measurable with sufficient reliability

3. relevance

4. reliability.

The ASB’s SOP points out that although the starting point for the recognition process may be the effect on assets and liabilities, the notions of ‘matching’ and the ‘critical event’ may help in identifying the effects. However, the SOP emphasises that ‘matching’ is not used to drive the recognition process. It seeks to prevent unrestricted use of the matching concept, otherwise it would be possible to delay recognition in the performance statement of most items of expenditure whose hoped-for benefits lay in the future. It restricts this by allowing only items that meet

Activity 2.3

What do the definitions of assets and liabilities above actually mean? Explain in your own words.

4 Chapter 4.

The objective of financial statements is achieved to a large extent through depicting in the primary financial statements, in words and by a monetary amount, the effects that transactions and other events have on the elements. This process is known as recognition.

5 The elements of financial statements are those discussed above such as assets, liabilities, ownership interest, gain and so on.


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the definition of assets, liabilities and ownership interest to appear in the balance sheet. Thus expenditure or losses not associated with control of rights or other access to future economic benefits will be recognised as a loss in the period in which they are incurred; and expenditure incurred with a view to future economic benefits where the relationship is too uncertain will be recognised as a loss immediately. However, it recognises that, for example, if future economic benefits are eliminated over several accounting periods, the cost of the asset that comprises those benefits will be recognised as a loss over the same accounting periods.

The SOP suggests that focusing on the critical event in the operating cycle may make it easier to identify gains arising from the provision of goods and services; this will be the point at which there is sufficient evidence that the gain exists and it can be measured reliably. This need not be at the time of full performance. The statement suggests that a contract to, for example, build large buildings might involve performing a series of stages for each of which there is a critical event. It suggests that ‘in such circumstances the gain that is expected to be earned on the contract as a whole will need to be allocated among the critical events.’6

The concept of realisation does not appear amongst the criteria for recognition in the SOP. In Appendix III the Board points out that, over time, even wider notions of ‘realisation’ have become irrelevant and, rather than choosing to ‘bend a term so that it has meaning other than its natural meaning’, the Board has chosen to focus on the underlying objective of recognising a gain only if there is reasonable certainty that it exists and can be measured reliably. ‘Although the realisation notion is one means of determining whether the existence of a gain is reasonably certain… in the Board’s view it is not necessarily the best way.’ In Appendix I the Board points out that although this appears to conflict with the Companies Act (which states that only profits realised at the balance sheet date may be included in the income statement), ‘the way in which the Act defines a realised profit means that the exact effect of this difference is not clear.’

However, the FASB states that to recognise revenues and gains the items should be (a) realised or realisable and (b) earned.

MeasurementAssuming that financial items satisfy the recognition criteria, at what amount should they be recorded in the financial statements? Should they be at cost, at market value or at some other amount? There are a number of different theoretical approaches to measurement, for example replacement cost or deprival value. Many of the different approaches are reviewed in this subject guide. The underlying argument regarding measurement is that there is no single valuation method that can meet all financial reporting purposes in all circumstances.

In the US, SFAC No. 5 dealt more with current practices than actual recommendations (and it received much criticism). For instance, it did not prescribe a particular measurement attribute to be used in given circumstances. Instead it listed five measurement attributes used in practice:

6 See Chapter 9.

Activity 2.4

What typically gives rise to ‘change’ needing to be considered for recognition?

If there is a change in an asset which is not offset by a change in a liability then where should the gain or loss be recognised? What are the conditions under which gains can be recognised in the income statement either in the UK or internationally?


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• historical cost

• current cost

• current market value

• net realisable value

• present value of future cash flows.

It concluded that ‘rather than attempt to select a single attribute and force changes in practice… this statement suggests that use of different attributes will continue.’ It notes that an ideal measuring unit would be stable over time but suggests that at times of low inflation nominal units of money are relatively stable; ‘the Board expects that nominal units of money will continue to be used to measure items recognised in financial statements’ but suggests that this might change if increased inflation led to ‘intolerable’ distortions. This is similar to the ASB who note that although most financial statements are prepared using the financial capital maintenance concept and measured in nominal units, adjustments will be needed if the problem of general price change is acute, and if the problem of specific changes 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.’

Little in the FASB statement is likely to lead to a change from existing US practice. Indeed, it largely reaffirms it. Paragraph 2 notes that ‘the recognition criteria and guidance in the Statement are generally consistent with current practice and do not imply radical change’ (though it notes the possibility of future change is not foreclosed – see also paragraph 91).

However, the ASB states, in Chapter 6 of the SOP, that the measurement is based on the assumption that a ‘mixed measurement’ approach (often referred to as ‘modified historical cost’)7 will be adopted, whereby some items will be measured at historical cost and others at current value. It suggests that ‘the basis selected will be the one that best meets the objective of financial statements and the demands of the qualitative characteristics of financial information, bearing in mind the nature of the assets or liabilities concerned and the circumstances involved.’

Following initial recognition, items will be remeasured, as necessary, to ensure that items measured at historical cost are carried at the lower of cost and recoverable amount, and items shown at current value are kept up-to-date.

The statement asserts that ‘current value is at its most relevant when it reflects the loss that the entity would suffer if it were deprived of the asset involved’ and therefore advocates a measurement basis known as ‘value to the business’ or ‘deprival value’, depicted diagrammatically in Figure 2.3.

(The concept of deprival value will be discussed in more detail later in the subject guide.)

Value to the business= lower of:

Replacement cost and Recoverable amount= higher of:

Value in use and Net realisable valueFigure 2.3 ‘Value to the business’ or ‘deprival value’

7 The ASB (1999) states that although the measurement basis noted above is often referred to as the ‘modified historical cost basis’, it is more accurately referred to as the ‘mixed measurement system’.


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The SOP notes that the ‘relief value’ of a liability may be selected in a similar manner.

It stops short of advocating a move towards current value accounting:

However, in discussing the choice of a measurement basis it makes the following points:

• As markets develop, measurement bases once thought unreliable may become more reliable.

• The need for relevant information means that the measurement basis should be one that provides information useful for assessing the entity’s ability to generate cash flows and its financial adaptability.

• If both historical cost and current value measures are available, the better one to use will be the one that is more relevant.

• Current value measures are not necessarily less reliable than historical cost measures; for example provisions for bad and doubtful debts under historical cost accounting involve estimates similar to (and of similar reliability to) those involved in ascertaining current values not derived from an active market.

• ‘Assessment of relevance and reliability needs to take into account what the asset or liability represents.’ It suggests that an investment which represents a ‘store’ of spare cash will best be measured at current value since its relevance to the entity will be the future cash flows that it represents right to.

An earlier exposure draft of the SOP was criticised by many as being an attempt to introduce a current cost accounting system. The SOP appears to play down the importance of fully blown, current-cost systems by suggesting that a mixed measurement system will continue to be used, though it refers to many advantages of current value. The statement refers to choosing the most relevant basis when both historical cost and current value are available and reliable, and the need to choose a measurement basis according to the nature of the assets, the particular circumstances, the objectives of financial statements and the qualitative characteristics of financial information. But can the mixed measurement system be justified in terms of ‘principles’? It also raises questions of comparability. Baxter comments that ‘such muddled figures hardly add to accounting dignity’.8

Presentation of financial informationChapter 7 of the SOP discusses the financial statements and the presentation of financial information. It identifies what constitutes good presentation in:

1. the statement of financial performance (the components of performance and their characteristics – ‘their nature, cause, function, relative continuity or re-occurrence, stability, risk, predictability and reliability’)

[I]t says nothing about the desirability or otherwise of adopting an approach that involves all balance sheet items being measured at current value, just as it says nothing about the desirability or otherwise of adopting an approach that involves all balance sheet items being measured at historical cost. All it does say is that both these approaches would involve a radical change to existing practice. (ASB, 1999)

8 Accountancy, October 1999.


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2. the statement of financial position (the types and functions of assets and liabilities and the relationships between them)

3. the cash flow statement (distinguishing in particular cash flows from operating activities, and those from other activities).

The statement notes the importance of aggregation, interpretation and simplification in portraying items in financial statements, to avoid excessive detail obscuring the message; the notes to the accounts should be used to amplify and explain the statements.

Accounting for interests in other entitiesChapter 8 of the SOP discusses how different investments in other entities should be reflected in a single entity’s accounts and in consolidated accounts. This involves issues, such as accounting for business combinations and entities over which there is significant influence, which are considered later, in Chapter 5 of this guide.

Review of the conceptual framework The IASB produced a Discussion Paper in 2006 – Preliminary views on an improved conceptual framework for financial reporting. Subsequently an Exposure Draft (with the same name) was issued in 2008. It was part of a series of initiatives developed jointly by the FASB and the IASB to provide a foundation for principles-based and converged standards. The focus is on information for providers of capital and substantively it is wedded to the conventions of previous influential frameworks. Let us review its qualitative characteristics.

Relevance and faithful representation are classified as fundamental qualitative characteristics. Faithful representation is meant to replace reliability – and hence is controversial, depending upon how it is interpreted. Comparability, verifiability, timeliness and understandability are classified as enhancing qualitative characteristics.

Specific attention is directed to ‘constraints of financial reporting’:

• Materiality: the report should not be cluttered with immaterial information: information is understood as material if its omission or misstatement would influence user decisions.

• Costs: Benefits of financial reporting should be greater than costs.

The emphasis on decision-usefulness is controversial for those who recognise the need to constrain disclosure in an imperfect markets context or who fear that the stewardship dimension might be overlooked. Some believe stewardship should be specifically referred to, perhaps even as a separate objective.

A further exposure draft in relation to this project was issued in 2010. This focused on the development of a reporting entity concept. This is again from the perspective of providers of capital seeking information they do not have about a ‘circumscribed area of business activity’. We shall consider the reporting entity concept further later in relation to group accounts.

Discussion on other areas, including elements and recognition, and, measurement, continue.


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ConclusionsThe ASB’s Statement of Principles in many respects resembles much of the existing practice. However, the SOP has played a significant role in the development of new Financial Reporting Standards (FRSs). As the ASB states ‘…all the standards that have been issued since then [i.e. after the SOP] are therefore based on those principles. Indeed, some of the principles play very significant roles in those standards [i.e. new standards]. For example:

• FRS 2 Accounting for Subsidiary Undertakings uses the reporting entity concept described in Chapter 2 of the statement

• FRS 4 Capital Instruments, FRS 5 Reporting the Substance of Transactions, FRS 7 Fair Values in Acquisition Accounting, FRS 12 Provisions, Contingent Liabilities and Contingent Assets, FRS 19 Deferred Tax, FRS 26 Financial Instruments: Recognition and Measurement all use the definition of assets and liabilities (where applicable) set out in Chapter 4;

• FRS 11 Impairment of Non-Current Assets and Goodwill uses the recoverable amount notion described in Chapter 6; and

• FRS 3 Reporting Financial Performance draws on the principles of good presentation described in Chapter 7.

• FRS 18 Accounting Policies and FRS 28 Corresponding Amounts draws on the qualitative characteristics of accounting information set out in Chapter 3.’

However the one major difference with existing practice revolves around the notion of ‘matching’. An earlier draft was also criticised for appearing to downgrade the importance of ‘matching’ in the accounting process. Many commentators saw the SOP’s focus on assets and liabilities as emphasising the balance sheet at the expense of the matching concept. They saw this as meaning that certain items which presently appear in the balance sheet as a result of the matching process (certain deferred debits/credits) would be excluded. They agreed that accounting should continue to be based on the recognition of transactions. The SOP retains the emphasis on assets and liabilities, but points out that transactions will continue to be the most common form of event affecting the elements and therefore the most common reason for recognising and de-recognising items in financial statements. However, it does not accord primacy to matching; the matching process will be restricted in that expenditure and losses will be carried forward only if there are economic benefits still to be derived from them. Baxter, in supporting this approach, points out that ‘matching’ is a misnomer:

[O]ften income rises or falls without a linked match. Thus overheads have no cause-and-effect links with particular revenues; neither have storm damage nor stores’ obsolescence; interest is earned without a cost and so on… If matching is unnecessary for such ‘unlinked’ assets changes, it cannot be essential to the income concept.

What matters are the changes in the assets… (Accountancy, October 1999)


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Reminder of learning outcomesHaving completed this chapter, and the Essential readings and activities, you should be able to:

• define a conceptual framework

• identify the main efforts by the US, the IASC and the UK to introduce a conceptual framework

• describe the objectives of financial reporting

• explain the ‘ideal’ qualitative characteristics of accounting information

• define assets and liabilities

• explain and describe recognition and measurement

• apply the conceptual frameworks to particular transactions; for instance, would they help in deciding how to account for research and development?

Sample examination questions

Question 2.1Select a ‘conceptual framework’ that is most relevant to your country or the country in which you are studying (e.g. FASB, IASC, ASB). Discuss the main arguments in favour of and against a conceptual framework in general and the strengths and weaknesses of the particular framework that you have selected.

Question 2.2The FASB’s conceptual framework was expected to:

a. guide the body responsible for establishing standards

b. provide a frame of reference for resolving accounting questions in the absence of a specific promulgated standard

c. determine bounds of judgement in preparing financial statements

d. increase users’ understanding of, and confidence in, financial statements

e. enhance comparability.

How feasible do you think are all of these expectations? What difficulties can you identify that the FASB might have in its attempt to satisfy all five expectations?

Question 2.3Evaluate efforts to date to re-orientate the conceptual framework for financial reporting that are part of the IASB and FASB convergence project.

Activity 2.5

How might a conceptual framework be used to counter lobbying by pressure groups whenever a new (contentious) accounting standard is proposed?

Contrast the UK approach to standard-setting (often allowing choices of accounting method) with the US approach (more detailed, specific).

Notes


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Chapter 3: Income measurement and capital maintenance

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Aims of the chapterThis chapter introduces different views of income and capital. One is often characterised as the view of accountants, the other is often characterised as the view of economists. The economist’s view is then considered further in terms of its possible implications for accounting.

Learning outcomesBy the end of this chapter, and having completed the Essential reading and activities, you should be able to:

• contrast the accountant’s and the economist’s approach to income and asset value measurement

• explain Hicks’s definition of ‘well-offness’ and measures of income numbers 1 and 2

• discuss ex ante income and both ex post incomes for Hicks’s income 1 and 2

• calculate income ex ante and ex post for both Hicks’s income measures

• discuss the implications of Hicks’s income measures for both economists and accountants.

Essential readingInternational Financial Reporting, Chapter 4.

Further readingBeaver, W.H. and J.S. Demski ‘The Nature of Income Measurement’, Accounting

Review 54(1) 1979.Bromwich, M. Financial Reporting, Information and Capital Markets. (London:

Pitman Publishing, 1992) [ISBN 9780273034643]. Chapters 3 and 4.Hicks, J.R. Value and Capital. (Oxford: Clarendon, 1946) second edition.

Chapter 14.Hicks, J.R. ‘Incomes’ in Parker, R.H., G.C. Harcourt and G. Whittington (eds)

Readings in the Concepts and Measurements of Income. (Oxford: Philip Allan, 1986) second edition [ISBN 9780860035367].

Lewis, R. and D. Pendrill Advanced Financial Accounting. (Harlow: Financial Times Prentice Hall, 2004) seventh edition [ISBN 9780273658498]. Chapter 4.

Paish, F.W. ‘Capital and Income’, Economica 7(28) 1940.Solomons, D. ‘Economic and Accounting Concepts of Income’, Accounting

Review 36(3) 1961 (reprinted in Parker, R.H., G.C. Harcourt and G. Whittington (eds) Readings in the Concepts and Measurements of Income. (Oxford: Philip Allan, 1986) second edition [ISBN 9780860035367]).

Whittington, G. Inflation Accounting: An Introduction to the Debate. (Cambridge: Cambridge University Press, 1983) [ISBN 9780521270557]. Chapter 2.


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A view of income and capital often characterised as the accountant’s view

The accountant is here understood as computing the income for a period by one or both of two approaches that logically give the same financial number:

1. Take revenues less the cost of sales and other expenses for a period to compute profit Y0→1 directly

2. Compute profit for a period by comparing opening and closing net assets, adjusting for new capital injections or withdrawals, thus (assuming no capital injections) calculating the value of NA1 – NA0 + D0–1

Y0→1 = NA1 – NA0 + D0–1

Where:

Y0→1 = profit for the period

NA1 = net assets at the end of the period

NA0 = net assets at the beginning of the period

D0–1 = distribution for the period.

Net profit here is the difference between opening and closing net assets before distributions: consistent here with seeing the balancing figure in the balance sheet as profit for the year. By this logic, beyond constraints of a particular view, income depends on valuation of net assets. The approach associated with the economist values net assets using net present values (NPVs).

A view of income and capital often characterised as the economist’s view

The relationship between income and capital can be expressed as:

Y0→1 = V1 – V0 + D1

Here V0 is the opening capital value, V1 is the closing capital value and D1 represents consumption (or expected cash flow to be received at the end of year 1). The value of the business is calculated using the present value of expected cash flows.

Activity 3.1

Compare and contrast the views of income and capital discussed above.

Activity 3.2

A business is set up by Zillah Corporations with an expected four-year life. At the start of 2010, the cash flows expected to occur at the end of the years to which they relate are:

£

2010 10,000

2011 8,000

2012 6,000

2013 4,000

Assume the interest rate is 10% and is expected to remain constant.

What would be the economic value of the business at the start of 2010 (i.e. V2010)?

The solution to this activity is given in Appendix 1.


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Hicks’s version of the economist’s concept of incomeMany accounting theorists have appealed to the notions of Economic Income developed by Sir John Hicks in his book Value and Capital.1 This is perhaps strange, as Hicks notes that income is a ‘rough approximation’, a ‘guide for prudent conduct’, whose purpose in practical affairs is ‘to give people an indication of the amount which they can consume without impoverishing themselves’. This leads to Hicks’s central concept of income:

(Note that Hicks uses ‘week’ to denote a period during which variations in price might be neglected in analysis; extreme inflatory conditions, for example, may problematise this.)

Although Hicks’s analysis relates to the individual, it has also been applied to measuring corporate income. The Sandilands Committee on inflation accounting based its proposals on Hicks’s central concept, defined for a company as:

The corporate equivalent of ability to consume is thus related to the dividend the company could pay.

What, then, does it mean ‘to be as well off’? Hicks spells out a number of practical ‘approximations’ to his central concept (see below).

Hicks’s income number 1Hicks’s first approximation (income number 1) is:

Actually, all Hicks’s constructs refer to the individual’s spending in a period, if in principle the key to each construct is the individual’s consumption during the period. Hicks notes that the measure of durable goods consumption could be difficult without satisfactory secondhand markets for the goods (if such markets exist, consumption can be measured by change in the goods’ value over the specified period).

Under Hicks’s number 1, ‘well-offness’ to be maintained is thus the NPV of future cash flows. Hicks sees this as the definition most people implicitly use in their private affairs, but as leading to ambiguities when interest rates change (see Hicks’s number 2 below). Let us assume all future cash flows occur at the end of each relevant period with certainty, and that there is one constant interest rate for borrowing and lending. Taking time 0 as the present time and time 1 as the end of the first period (say a year), we initially use the following notation:

D1 = the cash flow arising at time 1

V1 = the capital value at time 1 (= PV of future cash flows from time 1 onwards)

V0 = the capital value at time 0 (= PV of future cash flows from time 0 onwards).

1 See Further reading above.

the maximum value a person can consume during a week and still expect to be as well off at the end of the week as at the beginning.

the maximum value the company can distribute during the year and still expect to be as well off at the end of the year as it was at the beginning.

the maximum amount that can be spent during a period if there is to be an expectation of maintaining intact the capital value of prospective receipts (in money terms).


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The capital values are measured excluding dividends, i.e. V1 does not include the cash flow receivable at time 1 (D1). Income number 1 for the period from time 0 to time 1 (Y0→1) is thus measured as:

Y0→1 = D1 + V1 – V0

If the individual actually consumes this amount of income (assuming consumption in the period from t0 to t1 is all paid for at the time t1), then remaining wealth at t1 is V0, so the individual is as well-off at the end of the period as at the beginning. The above expression can be interpreted in two ways. First, we can write the expression as:

Y0→1 = (D1 + V1) – V0

The term in parentheses represents the total expected wealth, made up of net cash received plus the present value of expected future net receipts, at the end of the first period. So Y0→1 is the amount by which total wealth is expected to increase during the period.

The second way of splitting the expression above is:

Y0→1 = D1 + (V1 – V0)

This can be interpreted as dividing economic income into two components: the expected cash flow for the period and the expected change in the value of the individual’s wealth (excluding end-of-period cash D1). We might refer to the component in parentheses as an expected holding gain or loss. This should be distinguished from a windfall gain or loss (discussed below), which is unexpected.

Example 1: perpetuityA government bond pays £150 a year for ever. If the interest rate is 10%, then the capital value of the bond at time 0 (ex interest) is:

£150 = £1,500 = V00.1

At t1 the value of the bond (cum, or with, interest) is:£150 = £1,650 = V10.1£150 +

Therefore the income from the bond is:

Y0→1 = £1,500 – £1,650 = £150

This is the same each year, and the capital value remains at £1,500 (ex interest).

Example 2: an annuityAn annuity pays £150 p.a. at the end of each of the three years and costs £373.00. The interest rate is 10%. Analyse each year’s receipts into ‘income’ and repayment of ‘capital’. Assume that all the ‘income’ is spent and the ‘capital’ receipts are reinvested in a bank account which pays interest at 10%:


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£ 1 2 3 4 5 6 7 8 9

Opening value

Income from annuity (10%×1)

‘Capital’ receipt from annuity

Total receipts from annuity

Interest on bank deposit @ 10% (10% × 8)

Total income (2+5)

Capital value of annuity after payment

Bank balance

Total capital (7+8)

Time

t0 – – – – – – 373.00 – 373.00

t1 373.00 37.30 112.70 150.00 – 37.30 260.30 112.70 373.00

t2 260.30 26.03 123.97 150.00 11.27 37.30 136.33 236.67 373.00

t3 136.33 13.63 136.37 150.00 23.67 37.30 – 373.00 373.00

Thereafter the bank pays £37.30 interest each year on the balance of £373.00.

Applying the formulae above, we find:

V0 = £373.00

V1 = £260.30

D1 = £150

Y0→1 = £150 + £260.30 – £373 = £37.30

Note: The actual financing and consumption policy adopted will not alter the calculation of the income from the annuity in column 1.

Example 3: a ‘capital budgeting project’An investment project is expected to have the following cash outlays and receipts.

Time Cash Flows Discount Factor @ 10%

t0 – 4,000 1.0000

t1 +2,000 0.9091

t2 +1,500 0.8264

t3 +2,000 0.7513

Analyse the cash flows into ‘income’ and ‘capital’, on similar assumptions to the previous example above and assuming the initial outlay of £4,000 was borrowed via a bank overdraft.

Activity 3.3

If the cost of capital is 10%, what is the NPV of the project to the nearest £1?

The solution to this activity is given in Appendix 1.


54

£ 1 2 3 4 5 6 7 8 9

Opening value

Income from project (10% × 1)

Capital receipt or shortfall (4 – 1)

Total project receipts (payments)

Interest received/ (paid) to bank (10% × 8)

Total income (2+5)

Capital value of project

Bank balance (overdraft)

Total capital (7+8)

Time

t0 – – (4,000) (4,000) – – 4,560 (4,000) 560

t1 4,560 456 1,544 2,000 (400) 56 3,016 (2,456) 560

t2 3,016 302 1,198 1,500 (246) 56 1,818 (1,258) 560

t3 1,818 182 1,818 2,000 (126) 56 – 560 560

Therefore the bank account will pay £56 p.a. interest on the £560 balance.

Applying the valuation and income formulae above:

Project value at time 2 = £2,000 × (0.9091) = £1,818

Example 4: Cash flowsYour friend expects to get cash of £1,000 at time 1 and £2,000 p.a. thereafter (all cash flows arise at year end) in perpetuity. The rate of interest is expected to remain at 10% p.a. He wishes to consume all income, but no more, and can borrow from and lend to the bank at 10% p.a.

What is his income in year 1? Relevant variables are as follows:D1 = £1,000

(= cash flow at time 1)

(= PV of future cash flows from t0 onwards)

= £20,000V1 =£2,000

0.1

V0 =

(= PV of future cash flows from t1 onwards)£1,000

1.1+( (£2,000

0.1 = £909.09 + £18,181.82 = £19,090.911

1.1×

Therefore income number 1 equals £1909.09: £1,000 + £20,000 – £19,090.91 = £1,909.09

How can he consume £1,909.09 when the year’s cash flow is only £1,000?He only has cash of £1,000, but could borrow £909.09 from the bank at the prevailing rate of interest; this would reduce his capital at time 1 (V1) from £20,000 to £19,090.91 thus maintaining his original capital (V0).

Interest of £90.91 p.a. on the loan would reduce net future cash flows to (£2,000 – £90.91) = £1909.09 p.a. (Rather than borrow, he could realise £909.09 of the capital value at time 1 by sale, leaving capital value at £19,090.91, on which future receipts at 10% p.a. would be £1,909.09.)

Future income will remain at £1909.09 p.a. provided he exactly maintains his opening capital.

In this example income equals the rate of interest (r) applied to the opening capital value (i.e. rV0). This is because V0 equals (D1 + V1) discounted back one period by r, which in turns means that (D1 + V1) equals (1 + r)V0 ; income may thus be expressed as (1 + r)V0 – V0, or rV0.

It should also be noted that, on the assumptions made so far, if the opening capital is exactly maintained and all the income (including the accretion to

Project value at time 1 = £1,500 × (0.9091) + £2,000 × (0.8264) = £3,016


55

capital value) consumed, then in future years the income figure would be constant (and equal to rV0).

Summary of formulae:Y0→1 = D1 + V1 +V0

V0 = D1 + V1

1 + r

(1 + r)V0= D1 + V1

Y0→1 = (1 + r)V0–V0

Y0→1 = rV0

Income ex ante and income ex postIf we relax the assumption of certainty, problems arise. In addition to different people having different expectations about the future, in conditions of uncertainty actual cash flows will tend to differ from forecast cash flows. Moreover, new information or changing conditions will revise expectations about all future cash flows. Given these differences, we will have different amounts for the capital values at time 1 and time 0, and for the cash flow at time 1, depending on whether these were calculated at the beginning or end of the year.

We may call our calculations made at the beginning of the year, at t0, ex ante or ‘forward-looking’ and add the symbol ‘t0’ to show they were computed at time 0 in the light of the knowledge and expectations we had at that time. We may call our calculations made at the end of the year, at time 1, ex post, or ‘backward-looking’ and add the symbol ‘t1’ to show they were computed at time 1 in the light of our revised knowledge and expectations. We use the following notation:

Ex ante variables

D1t0 = the cash flow we expect to receive at time 1, given our knowledge and expectations at time 0

V1t0 = the expected capital value at time 1, given our knowledge and expectations at time 0

V0t0 = the opening capital value at time 0, given our knowledge and expectations at time 0 (This will equal (D1t0 + V1t0) discounted back one period at the rate of interest for that period.)

Ex post variables

D1t1 = the actual cash flow occurring at time 1

V1t1 = the capital value at time 1, given our revised knowledge and expectations at time 1

V0t1 = the revised calculation of our opening capital value given the actual cash flow for the year and our revised expectations at the end of the year. (This will equal (D1t1 + V1t1) discounted back one period at the rate of interest prevailing for that period.)

Given these differences between ex ante and ex post calculations, we now have different measures of income number 1 depending on the time the income number is calculated.

Income number 1 ex anteFirst of all, we may calculate income ex ante, or ‘forecast’ income based entirely on our expectations at the beginning of the period, time 0. For Hicks, this is the figure relevant to decisions. This makes sense if


56

income is regarded as a guide to consumption. Income number 1 ex ante may be expressed as:

Number 1 Y0→1 ex ante = D1t0 + V1t0 – V0t0

As noted earlier, this equals rV0t0. For the reason given above, income number 1 ex ante will always equal interest on the capital value at the start of the period.

Income number 1 ex post version A and version BWe may alternatively (or in addition) calculate income number 1 ex post, income for the period calculated at the end of the period. There are, however, two possible versions of income number 1 ex post, which we will call ‘version A’ and ‘version B’.

They differ in their treatment of windfall (unexpected) gains and losses. Windfalls (unexpected) arise from differences between:

• forecast and actual cash flows for the period

• original expectations of future cash flows from the end of the period onwards and our revised expectations of future cash flows.

(They may also arise from differences between expected and actual interest rates, or changes in expected interest rates, but we are as yet assuming constant interest rates.)

Version AVersion A may be expressed as:

Income number 1 Y0→1 ex post version A = D1t1 + V1t1 – V0t0

This is actual cash flow for the period plus capital accumulated including windfalls. Hicks describes income ex post as income ex ante plus windfalls. Thus the definition of ex post income incorporates all windfalls measured as:

(D1t1 + V1t1) – (D1t0 + V1t0)

Here, income is no longer equal to rV0t0 (because windfalls are not reflected in the opening capital value).

It could be argued that the definition of Hicks’s income 1 ex post version A set out above is meaningless as it compares two numbers calculated using information available at time t1 with a number calculated using only information available at time t0. If the individual had the information at t0 that the individual has at t1, the individual’s calculation of NPV would not have been the originally calculated V0t0 but rather:

V0t1 = (D1t1 + V1t1)1

1+r

This gives an alternative version of ex post income: version B.

Version BVersion B may be expressed as:

Income number 1 Y0→1ex post version B = D1t1 + V1t1 – V0t1

This is actual cash flow for the period, plus capital accumulation excluding windfalls.

Windfalls are excluded because we have restated our opening capital with the benefit of hindsight to what it would have been had we had perfect foresight at t0. This measure would therefore have been our ex ante income number 1 if we had had perfect knowledge at t0; it follows that income under this version is equal to rV0t1.


57

The treatment adopted for these ex post windfalls determines our ex ante income for future periods (assuming we consume all income). Including them in income under version A maintains our originally foreseen capital value as the basis for measuring future income ex ante and (assuming constant interest rates) our ex ante income for the next period would equal ex ante income for this period (rV0t0). Excluding them from income as per version B maintains revised opening capital value as the basis for future ex ante income and (assuming constant interest rates) ex ante income for the next period would equal ex post (version B) income for this period (= rV0t1). Thus this second version of ex post income is closer to Hicks’s own intentions than version A.

Example 5A project is expected to generate cash flows of £10,000 p.a. in perpetuity. The interest rate is expected to remain at 10% p.a. Cash flows arise at year end. At the end of the first year the actual cash receipts are £5,000. At that time, expectations of future cash receipts are changed to £12,000 p.a. The interest rate for the first year is 10% and is expected to remain unchanged.

1. What is the income for the first period (i) ex ante and (ii) ex post?

2. Reconcile the ex ante income with both versions of ex post income.

At time 0 and time 1 we have the following information:

ex ante Beginning of the year

currently here

t0 t1 t2 t3 tCash flows 10,000 10,000 10,000 10,000

D1 0 ………….… V 1t0 ………

V 0t0 ………………………………………………………………………

ex post End of the year

currently here

t0 t1 t2 t3 t4

Cash flows 5,000 12,000 12,000 12,000

D1t1 …………. … V 1 1 ……………………

V 0 1t

t

……………………………………………………………………… →

→

→ 8

4→ 8

→

→

→

→

→

→

→→

D1t0 = £10,000 D1t1 = £5,000

V1t0 = £10,000

= £100,0000.1

Ex ante variables

V0t0 = £10,000

= £100,0000.1

Ex post variables

V1t1 = £12,000

= £120,0000.1

V0t1 = £5,000

= £113,6361.1


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Income 1 ex ante,

Y0→1ex ante= D1t0 + V1t0 – V0t0

= £10,000 + £100,000 – £100,000 = £10,000

(= 10% × £100,000 = rV0t0)

Income 1 ex post,Y0→1

ex post version A = D1t1 + V1t1 – V0t0

= £5,000 + £120,000 – £100,000

= £25,000

(no longer equal to interest on the opening capital value).

Y0→1ex post version B = D1t1 + V1t1 – V0t1

= £5,000 + £120,000 – £113,636

= £11,364

(= 10% × £113,636 = rV0t1)

Note that even if ex post income is based upon knowledge of the actual cash flow that we know at time 1, it is still based upon expectations of the future from time 1 onwards; V1t1 still measures expected future cash flows discounted at the expected rate of interest. Thus, income ex post is still a very subjective measure.

Reconciliation £

1. Budgeted income for year (ex ante)

Revision of current cash flow (D0t1 – D1t0)

Revision of forecast cash flows

Income for the year (ex post) version A

2. Budgeted income for year (ex ante)

Revision to capital value at beginning of the year due to:

Decrease in actual cash flow 5,0001.1

=

Revision to forecasts after t1:2,000

0.1

–

+

Net change

Add interest on net change 13,637 @ 10%

Income for the year (ex post) version B

£10,000

<5,000>

£20,000

£25,000

£10,000

£18,182

£13,637

£1,364

£11,364

×1

1.1=

+2,0000.1

<4.545>

What if interest rates are expected to change?So far interest rates have been assumed to remain constant. What happens if interest rates are expected to change, or change unexpectedly? How does this affect our concept of income? We have already noted with income number 1 that unexpected changes in interest rates would give rise to windfalls through the effect on capital values (see also example 7 below). But Hicks goes further and suggests that once we allow for changes in the rate of interest we must change our ideas about what constitutes ‘well-offness’ and hence our ideas about income measurement.

Now that interest rates are allowed to change, the following additional notation will be used:


59

Ex ante variables

r0t0 = the interest rate from time 0 to time 1, given our knowledge and expectations at time 0


rnt0 = the interest rate from time n to time n + 1, given our knowledge and expectations at time 0

Ex post variables

r0t1 = the interest rate that actually prevailed from time 0 to time 1


rnt1 = the interest rate from time n to time n + 1, given our knowledge and expectations at time 1

Example 6A security pays £200 a year forever. At time 0 the interest rate is expected to be 10% p.a. for the first two years and 20% p.a. thereafter. All cash flows arise at year end. At the end of each year the difference between income (calculated on a number 1 basis) and cash received is invested in a bank account at the prevailing interest rate so as to maintain the opening capital value. What is income number 1 ex ante for each of the first three years?

Ex ante variablesD1t0

V2t0

V1t0

V0t0

r0t0 = r1t0 = 10%

r2t0 = 20% = rnt0 for all n from 3 to infinity

= £200 (= Dtn0 for all n from 2 to infinity)

=£2000.2

= £1,000 (Vnt0 for all n from 3 to infinity)

=£2001.1

++ ( £2000.2

×1

1.1

(

= £1,090.91

=£2001.1

++ £200(1.1)2 ++ ( £200

0.2×

(

= £1,173.551

(1.1)2

Y0→1 = £200 + £1,090.91 – £1,173.55 = £117.36 (=10% × £1,173.55)

£82.64 will be invested in the bank, so that total capital at time 1 is now £1,173.55 (i.e. the security valued at £1,090.91 plus the bank balance of £82.64). The expected capital value at time 2 is now the security valued at £1,000 plus £82.64 in the bank, a total of £1,082.64. The bank pays interest of £8.27 (rounded) at t2 so that cash receipts at time 2 total £208.26.

Y1→2 = £208.27 + £1,082.64 – £1,173.55 = £117.36

£90.91 will be invested in the bank at t2, so that total capital (security plus bank balance) is once more maintained at £1,173.55; the total amount now in the bank is £173.55 (i.e. £82.64 plus £90.91), on which interest at 20% will be £34.71 p.a. Future cash receipts will therefore total £234.71. Capital value at time 3 will consist of the security valued at £1,000 and the bank deposit of £173.55 = £1,173.55.

Y2→3 (and each year thereafter) = £234.71 + £1,173.55 – £1,173.55 = £234.71


60

Since the capital value is henceforth expected to be constant, and the interest rate to remain constant at 20%, ex ante income for period 3 onwards will be £234.71 p.a. for ever. Thus, according to Hicks’s income number 1 ex ante, the income stream here will be £117.36, £117.36, £234.71, £234.71,…,£234.71.

But in these circumstances Hicks suggests that someone who could consume that pattern of income appears to be getting better off over time as the prospect of spending £234.71 a year draws nearer; one may be thought better off if one can consume £234.71 a year rather than £117.36 a year. Yet in his central concept Hicks has defined income as the amount one can consume during the year while remaining as well-off at the end as at the start; thus, there would be no change in one’s well-offness.

Hence Hicks suggests that maintenance of the capitalised value of prospective money receipts does not correspond with our ideas of well-offness when interest rates change.

Hicks’s income number 2The possibility that individuals could exploit changes in interest rates to change their consumption pattern leads Hicks to develop his second approximation of income:

For a company we may define it as:

When interest rates are not expected to change (and do not change), this will be the same as income number 1; if interest rates are expected to change (or do unexpectedly), the two income measures differ and Hicks regards number 2 as a better measure of income and closer to his central concept. In example 6 above, income number 2 would be £200 every year – the amount the security pays every year regardless of the interest rate.

Note also the effect of an unexpected change in the interest rate on income number 1, ex post, compared with income 2, even when cash flows are regular perpetuities.

Example 7A bond pays £100 at the end of each year forever. The rate of interest is expected to be 20% p.a. forever (i.e. r0t0 = rnt0 for all n from 1 to infinity), so the bond’s value is £500 (i.e. 100/0.2). At time 1 the interest rate (r1t1) unexpectedly changes to 10% and is expected to remain at 10% forever thereafter (i.e. r1t1 for all n from 2 to infinity); the bond’s value therefore rises to £1,000 (i.e. 100/0.1). The revised opening capital value is:

V0t1 =(D1t1 + V1t1)

1.2= £916.66=

100 + (100/0.1)

1.2

Income ex ante, both number 1 and 2, is £100 (= 20% × £500, i.e. r0t0(V0t0)) since the interest rate is not expected to change.

Income number 1 ex post version A is: 100 + 1,000 – 500 = 600

Income number 1 ex post version B is: 100 + 1,000 – 916.66 = 183.34.

the maximum amount the individual can spend this week and still expect to be able to spend the same amount in each ensuing week.

the maximum dividend the company can pay in a period and still expect to be able to pay the same dividend in all future periods.


61

Although this is 20% on the revised opening capital value (i.e. r0t1(V0t1)) note that future income ex ante will no longer be this amount, but (assuming that all of the income is consumed so that the capital is maintained at V0t1) will be 10% × £916.66 = £91.66 (i.e. r1t1(V0t1)).

But here income number 2 still measures ex post income as £100. The constant annual cash flow is unaffected by the change in the interest rate; it is therefore the amount that can be spent this period with the expectation of being able to spend the same amount in all future periods.

(As noted below, however, if cash flows are not regular perpetuities, an unexpected change in the rate of interest will affect income number 2 ex post.)

Number 2 ex anteWhen the net cash flows are regular perpetuities, income number 2 ex ante will equal the amount of the net cash flows. If they are not regular perpetuities but interest rates are assumed constant, it will (as noted above) equal income number 1 ex ante. If the cash flows are not regular perpetuities and there are expected changes in the interest rate, calculation of income number 2 ex ante is more difficult. Assuming, however, that just one change is expected, at time 1, after which rates are expected to remain constant (i.e. r1t0 = rnt0 for all n from 2 to infinity), then income number 2 ex ante may be calculated by solving for Y in the following:

V0t0 = + ( Yr1t0

×1

1 + r0t0

(

1 + r0t0

Y

where Y equals the amount of the annual income. This reflects the fact that the constant annual stream of consumption when discounted at the prevailing interest rates must have a present value equal to the opening ‘well-offness’ or capital value. In the case considered here, it may be solved also by finding income (Y) such that:

Number 2 ex postIncome number 2 will be affected if there are differences between expected and actual cash flows or differences between originally expected cash flows and our revised expectations of those cash flows. Once again we will have ex post measures. Moreover, there will again be two different measures of ex post income, depending upon how we treat windfalls. Income number 2 ex post version A may be defined as:

This version treats as windfall gains or losses all end-of-year period wealth that is not needed to generate in future periods the initially determined Hicks’s number 2 income ex ante. The second version of ex post Hicks’s number 2 aims to calculate the amount that, if consumed in the first period, will leave enough wealth to permit the individual to consume the same amount in all subsequent periods. Income number 2 ex post version B may be defined as:

Y = (1 + r1t0)

(V0t0)(r1t0)(1 + r0t0)

the maximum amount an individual can consume in a period and still expect to be able to consume the originally foreseen number 2 ex ante income in all future periods.

the maximum amount an individual can consume in a period and still expect to be able to consume the same amount in all future periods.


62

It therefore follows the basic definition of number 2, but calculates as income what would have been the ex ante income had one, at time 0, had the knowledge and expectations that one has at time 1. It therefore excludes windfalls from income.

When the cash flows are not regular perpetuities, an unexpected change in the interest rate will also affect income number 2 ex post, because of the additional borrowing and lending necessary to achieve the equalised stream of consumption.

Example 8A project is expected to generate cash flows of £2,000 per annum in perpetuity. The rate of interest is expected to remain constant at 10%. £2,000 is actually received at time 1, but at that time the rate of interest suddenly changes to 20% and is expected to remain at that level forever. Also at that time, expectations of future cash flows are changed to £4,000 per annum forever. All cash flows arise at the end of the year.

What is the income for the first period?

Ex ante Beginning of

the year

currently

here

t0 t1 t2 t3 t

Cash flows 2,000 2,000 2,000 2,000

V 0t0 D1t0 ……….… V 1t0 ………

r0t0 = 10%

(= rnt0 for all n from 1 to infinity)

Ex post End of the year

currently here

t0 t1 t2 t3 t

Cash flows 2,000 4,000 4,000 4,000

V 0t1 D1t1 ……….… V 1t1 ………

r1t1 = 20%

(=rnt1 for all n from 2 to infinity)

↓

↓

→ →

→→

4→ 8

4→ 8

At time 0 and time 1 we have the following information:Ex ante variables Ex post variablesD1t0 = £2,000 D1t1 = £2,000

V1t0

£2,000= 0.1 = £20,000

V0t0

£2,000= 0.1 = £20,000

V1t1

£4,000= 0.2 = £20,000

V0t1

£2,000= 1.1

£20,000+ 1.1 = £20,000

Income number 1 ex ante and income number 2 ex anteThese both equal £2,000 per annum since the interest rate was not expected to change.


63

Income number 1 ex postThis would also equal £2,000 as capital values at time 1 and time 0 are unchanged at £20,000.

Income number 2 ex post version AGiven that there is only one change in the interest rate and it is expected to be constant from time 1 onwards, income number 2 ex post version A may be calculated as follows. The original number 2 ex ante income was £2,000. To maintain it in the future at 20% p.a. requires capital of only £10,000 (i.e. 2,000/0.2). Since the capital value at time 1 (v1t1) is £20,000, £10,000 of that may be consumed as income this year, which, added to the actual cash flow for the period, gives total income for the year of £12,000. This may be expressed as:

Y = D1t1 + V1t1 –Original number 2 ex ante income

r1t1

To consume this income it would be necessary to sell £10,000 of the capital value at time 1, or to borrow £10,000 at 20%.

Reconciliation £

Budgeted income for year ex ante

Change in forecasted cash flows +

Change in interest rate

Income for the year ex post version A

+2,0000.1

2,000

20,000

<10,000>

12,000

=

2,0000.2

– 2,0000.1

=

Income number 2 ex post version BIncome number 2 ex post version B may be calculated by making use of the fact that the revised standard stream of consumption from time 0 onwards must have a present value, when discounted at the prevailing interest rates, equal to the revised opening capital value (v0t1). Thus,

V0t1 = + ( Yr1t1

×1

1 + r0t1

(

1 + r0t1

Y

where Y equals the amount of the annual income.

Thus:

2,000 = + ( Y0.2

×1

1.1

(

1.1Y

which, when solved for Y, gives income of £3,666.67. In order to consume this, capital of £1,666.67 must be realised by sale (or borrowed at 20%), leaving £18,333.33, on which income at 20% p.a. will be £3,666.67.

Here, this may alternatively be calculated by solving for:

Y = r1t1(D1t1 + V1t1 – Y )

which eventually resolves to:

Y =(1 + r1t1)

r1 t1(D1t1 + V1t1)


64

Reconciliation £

Budgeted income for year ex ante

Change in forecasted cash flows

Interest on revision capital @ 20% (8,333.33 × 0.2) =

Income for the year ex post version B

+2,0000.2

2,000.00

1,666.67

× 11.2

= 8,333.33

3,666.67

Note that this is the only ex post income measure that involves no looking backwards. The other figures are based on information at time t0 or use the interest rate that has just passed. Hicks’s income number 2 ex post version B uses only end-of-year realisations of cash flows and capital values and prospective interest rates.

Hicks’s income number 3Hicks’s recognises that even income number 2 is not the end of the story, because if prices are changing we want to be able to consume the same amount in real terms each week: we need a standard stream of real consumption. He therefore defines approximation number 3 as:

Hicks sees that the problem with calculating this lies in finding an appropriate index number of prices – a problem we return to in our discussions of current purchasing power accounting in Chapter 4.

Implications of Hicks’s measures of incomeHicks’s price-level income is not uniquely defined. Even ignoring contrasting changes, and calculation to income numbers 1 and 2, the result is six different measures of income.

Does this matter?

Hicks observes that all definitions are based on an individual’s expectations. Income has been defined as a forward-looking, ex ante concept. This makes sense if income is a guide to consumption. But what happens if expectations are not achieved? Hicks notes that the value of an individual’s prospective receipts at the end of the period can be more or less than the same value determined at the beginning of the period. In other words, the information available to the individual at the end of the period may lead to revision of the original calculation of the capital value of prospective receipts. Basing his discussion on income number 1, Hicks calls increases or decreases in the capital value of prospective receipts at the end of the period windfall gains or losses, and describes income ex post as income ex ante plus windfall gains less windfall losses.

Although Hicks acknowledges that ex post measures of income might have usefulness as historical measures of activity, he sees no role for them in economic analysis, as ex post measures (by definition) come too late to affect individual decision making. This leads him to argue that windfall gains and losses will come into future income calculations.

Thus Hicks concludes that income is a ‘very dangerous term’, that ‘the concept is one that a positive theoretical economist only employs in his argument at his peril’ and that income is ‘a bad tool which breaks in our hands’.

the maximum amount of money which the individual can spend this week and still expect to be able to spend the same amount in real terms in each ensuing week.


65

Implications for accountantsUsing income as a basis for sharing out rewards from past performance (‘ex post settling up’) depends in part on an updated view of likely future performance.

One version of income ex post (A above) would be objective if the capital values at the beginning and end of the period were fully represented by assets whose values were established in perfect markets. The assets of many manufacturing and trading businesses illustrate that this is not reality. Such assets are specific and not regularly traded, and the businesses’ prospects of future earnings depend largely on the skills of the company’s employees, established trading relationships, reputation for product quality, market power and so on; in other words the value of these businesses comprises a large element of ‘goodwill’ whose value is essentially subjective.

The other version of income ex post (B above) is subjective, relying on estimates of what the opening capitalised value of the prospects would have been at the beginning of the period if information available now had been available then.

From a decision-making perspective, calculation of income ex post has value primarily in terms of budgetary control (i.e. monitoring of outturn and revision of plans in order to learn from mistakes in the hope of improving future decisions). The ex post incomes have little significance on their own for future decisions – these must be based on the new calculation of income ex ante for future periods (which version B also provides). As calculation of the new income ex ante includes the capital value now, this does suggest that information on the present market values of assets (i.e. current wealth endowment) may be helpful, to both management and shareholders, in forming their estimates of a company’s likely future prospects. Although such estimates must be subjective, it could be helpful for shareholders to be given the management’s estimates, since these are the basis on which the management are reinvesting the shareholders’ money.

So what is the value in studying these theoretical concepts of income?

The value lies not so much in deriving prescriptions for accounting, as in the appreciation of the following limitations of any practical income measurement:

1. There can be no objective income measurement (including historical cost); actual cash flows may be seen as objective financial results. Any attempt at income measurement requires valuations which in most cases are subjective and cannot be ‘correct’.

2. Income measurements based on changes in the value of the recorded ‘net assets’ of a business can give only a partial picture of the changes in the value of the business as a whole.

3. Income measurements ‘ex post’ are not in themselves useful for management’s or shareholders’ investment decisions. They may help to improve decision-making (through comparisons with previous plans), but are only helpful for current and future decisions in so far as they can assist the formation of expectations about the future. Some would argue that ex post measures are useful as ‘control’ information (i.e. providing feedback for assigning responsibility and for corrective action). But Solomons (1961) argues that two coupled factors also severely limit the potential of ex post income measurement for control:


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the general impossibility of identifying how much of any variance from, or revision to, a plan is ‘controllable’ and therefore the responsibility of the relevant manager

the inherent subjectivity in making revised expectations about the future.

Reminder of learning outcomesHaving completed this chapter, and the Essential reading and activities, you should be able to:

• contrast the accountant’s and the economist’s approach to income and asset value measurement

• explain Hicks’s definition of ‘well-offness’ and measures of income numbers 1 and 2

• discuss ex ante income and both ex post incomes for Hicks’s income 1 and 2

• calculate income ex ante and ex post for both Hicks’s income measures

• discuss the implications of Hicks’s income measures for both economists and accountants.

Documents

Financial reporting - University of London · Presentation of financial information.. ... (HCA) and accounting for changing prices/values ... Final thoughts