Where do I start? The Framework of course!

The Framework

If you are new-ish to IFRS, and have literally 5 minutes to learn IFRS, then – learn the principles.

If you are new-ish to IFRS, and have more than 5 minutes, then – start with learning the principles.

If you are not new, then here’s a quick revision for you.

The laws of physics of IFRS is set out in the IASB’s ‘Conceptual Framework for financial reporting’. All new IFRS standards must comply with the Framework. And the need for Framework has arisen due to past events such as:

• Inconsistent guidance in accounting treatments within standards.
• Inconsistencies in application of prudence versus accruals/matching concepts.
• Standards are not comprehensive and do not (and of course cannot) cover all potential future and current accounting issues. Therefore, standards are argued to be ‘firefighting’ (i.e. issued after an accounting scandal). The Framework would on the other hand produce a set of principles to govern accounting issues, covered or not, by accounting standards (think… cryptocurrencies!?).

So, when you are thinking of posting an accounting entry tomorrow, if you simply and with good intention follow the Framework, you can’t go too wrong with IFRS. In contrast, with rules-based US GAAP you’d have to find the ‘debits and credits’ of your entry prescribed to you by the relevant standard.

How does the Framework ensure that financial information “in accordance with IFRS” is useful? Firstly, by providing comparability (with other companies and with past information), relevance (information is relevant to shareholders, creditors and other stakeholders), completeness (free from material error and omittance), verifiable, timely, and understandable.

Tomorrow, when you are posting that accounting entry, first identify where does your transaction or balance fit in within the following ‘5 elements of the Framework’:

1. Asset – a resource controlled by the entity as a result of past events, from which future economic benefits are expected to flow to the entity.
2. Liability – present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow of economic benefits from the entity.
3. Equity – a residual interest in the assets of the entity after deducting all its liabilities.
4. Income – the increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increase in equity, other than those relating to contributions from equity participants.
5. Expense – decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.

I know, I know… I’m starting to use accounting language here. Let us go through the above definitions, this time in plain English.

Asset is:

• Resource: This can be both tangible (e.g. computer you are using) and intangible (e.g. certain software licenses that you have on your computer).
• Controlled by the entity [by you]: Not necessarily legally owned by the entity. Although, you probably legally own your computer, most Airlines don’t actually own ‘their’ airplanes but lease them from leasing/financing institutions. However, they clearly control the planes, don’t they? Hence for them, the airplanes in accordance with IAS 17 (Leases) (coming soon) are leased assets.
• As a result of past events: This can be purchase, a receipt of a gift, exchange of assets, or signing of a finance lease.
• Inflow of future economic benefits: A very important concept here is that an asset must be able to generate future economic benefits. Would you recognize an asset if you’ve paid last month’s salary to your staff, paid for your own lunch or repainted your office yellow? Probably not, as these costs would not bring future economic benefit to you.

On the other hand, if you pay next month’s salary to your staff in advance (de facto staff loan), buy food for reselling in your supermarket (inventory), or build a factory to produce computers, you’d debit your balance sheet and recognize asset. This is because inflow of future economic benefits is expected from these transactions.

Liability is:

• ‘Present’ obligation: Word ‘present’ here is easy to miss and ignore, but this word is as important to the definition of liability as any others. Present obligation does not mean, that the settlement is due now or on demand. A liability, like an asset, can be both current and non-current (e.g. long-term corporate bond due in 5 years).

I’ll give you an example of an obligation which is not ‘present’. If you bet $100 that Manchester United wins the premier league (which, let’s say is highly unlikely this year), you wouldn’t have a present obligation to pay me. However, if due to occurrence of unlikely events, it is now probable that Manchester United becomes the champion, then a present obligation occurs and you would create a liability (i.e. provision) for probable outflow of future economic benefits, in accordance with IAS 37 (Provisions, contingent liabilities and contingent assets) (coming soon).

• Present ‘obligation’: Obligation does not have to be legally or contractually binding obligation, like the $100 bet above (which was legally binding in many jurisdictions as we both verbally agreed).

Obligation can be ‘constructive obligation’. This is when you have indicated to others, through your actions, that you will accept certain responsibilities. As a result, you have created expectations that you will discharge those responsibilities. For example, if you’ve always paid bonuses to your staff in January, and again expect to pay bonus this financial year, you have a constructive obligation to pay bonuses and hence liability (provision), even though the obligation is not legal.

However, as obligation has to be present obligation, you cannot create provisions for future commitments (e.g. you cannot create a provision on this year’s balance sheet, with the intention of increasing staff salaries in coming years).

Equity is:

• Residual interest: As equity is defined as ‘nothing but a balancing figure’ between assets and liabilities, this highlights the highest importance given by the Framework to identify and measure all the assets and liabilities of the entity in accordance with IFRS. Equity can be divided into different types of capital and reserves. This is usually done to show legal restrictions of shares or differing rights of various equity-holders.

Income is:

• Increase in economic benefits: Well, there you go… this is called “the Balance Sheet approach”. Income is basically defined as an increase in assets or decrease in liabilities (that result in increase in equity).
• But, other than those relating to contributions from equity participants: i.e. equity contribution could potentially increase cash (and hence ‘assets’), but should not result in recognition of income, as this is a transaction with equity participants. You would just Dr. Cash and Cr. Equity (share capital) on receipt of cash from equity participants for issuance of shares.

Expense is:

• Decrease in economic benefits: Opposite of income, an expense is a transaction that would decrease assets or increase liabilities (that results in decrease in equity).
• But again, other than those relating to distributions to equity participants: i.e. dividend distribution could potentially decrease cash (and hence ‘assets’), but should not result in recognition of expense, as this is a transaction with equity participants. You would just Dr. Equity (retained earnings) and Cr. Cash when distributing dividends.

Underlying assumption – Going concern

The underlying assumption of the Framework is that financial statements are prepared on the basis of a going concern. That is, the entity will continue its operations for the foreseeable future. As an auditor, we used to assume that foreseeable future is 12 months from the date of audit opinion. Kind of short-sighted auditors!

Here’s my promise to write a post on going concern and how to prepare financial statements (coming soon) if your entity is no longer going concern (i.e. break-up basis).

Underlying assumption – Accruals

Another underlying assumption of the Framework is that income and expenses are recognized on an accrual basis. This is in contrast to cash-based accounting. The transactions should be recorded when they have occurred, regardless of when and whether they were settled.

A simple example can be staff bonuses paid after the financial year, but which relate to the results of the financial year just ended. Even though cash outflow was in January 2019, the expense in this scenario should be recorded for the financial year ended 31 December 2018. This is consistent with the recognition of the liability for staff bonuses (remember constructive obligations?) as at 31 December 2018.

And finally – Materiality

You must have heard of the phrase “free from material error”. Well the concept of materiality in IFRS is to define a threshold to determine whether items are even relevant. The Framework (paragraph QC11) defines materiality as follows:

“Information is material if omitting it or misstating it could influence the decisions that users make on the basis of financial information about a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report.”

Now, it’s a judgement call here. But you can use the following as a starting point:

• 5% to 1% of total revenues;
• 1% of total assets;
• 2% to 5% of net assets;
• 5% of net profit.

And of course, certain items can be qualitatively material to the financial statements, regardless of their size. Examples of such items are disclosure of [dodgy] related party transactions and balances, transactions that could change net profit to net loss, net assets to net liabilities, etc., legal cases and other non-compliances and many more.

Bonus – What the Framework does not tell you

I’ll add one more guiding principle which is an underlying concept in IFRS – Substance over form. The Framework does not identify ‘substance over form’ as one of its principles, but it will have a special place here, at least in my blog.

Transactions and balances recorded in the financial statements should reflect their economic substance and reality, not their mere legal form. You see this everywhere in IFRS, but IAS 17 (Leases) is the easiest standard which I can point out to. If you go to your bank and agree a contract to sell-and-leaseback your home for 25 years with an option to buy-back at a discounted price, you are getting into a financing transaction (i.e. loan). Therefore, even though legally you sell your home, and it no longer is yours, in IFRS you would never ‘de-recognize’ it. You would recognize the liability in the form of finance lease payable to the bank, and would recognize cash received from the bank as asset. See IAS 17 (Leases) (coming soon) to learn more about this standard.

In the Framework, IASB refers to the above as faithful representation of transactions.

And, there you go. You have completed your learning of IASB’s conceptual framework. Remember(!), your aim in preparing financial statements should be true and fair representation of economic substance of your entity. This requires transparent, high-quality, consistent, relevant, complete, and unbiased financial information that is timely, comparable and verifiable.

Yours,

JU