Summary FAC1601 - Financial Accounting And Reporting Volume 2 2022.

FAC1601 - Financial Accounting And Reporting Volume 2 2022. (a) Comparability Information about a reporting entity is more useful if it can be compared with similar information about other entities and with similar information about the same entity for another period or another date to enable the user to make an informed decision, for example, in which entity to invest or to keep an investment in a specific entity (Conceptual Framework .QC20). Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items. Unlike the other qualitative characteristics, comparability does not relate to a single item. To compare there must be at least two items (Conceptual Framework .Q21). Consistency, although related to comparability, is not the same. Consistency refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities. Comparability is the goal; consistency helps to achieve the goal (Conceptual Framework .QC22). Chapter 1: Introduction to the preparation and presentation of financial statements 11 (b) Verifiability Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Verifiability helps ensure users that information faithfully represents the economic phenomena it purports to represent (Conceptual Framework .QC26). (c) Timeliness Timeliness means having information available to decision-makers in time to be capable of influencing their decisions (Conceptual Framework .QC29). (d) Understandability Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyses the information diligently. Classifying, characterizing and presenting information clearly and concisely makes it understandable (Conceptual Framework .QC30, 32). 1.2.5.3 The cost constraint on useful financial reporting Cost is a pervasive constraint on the information that can be provided by financial reporting. The cost of providing financial reporting must be justified by the benefits of reporting that information. Users ultimately bear those costs in the form of reduced returns (Conceptual Framework .QC35; .QC36). It is obvious that the benefits derived from the information in financial reporting should exceed the cost of providing it. 1.2.6 Elements of financial statements 1.2.6.1 Introduction The recording of transactions in the journals and ledgers of an entity provide the information needed to prepare financial statements. The information that is going to be used in the preparation of financial statements is grouped into elements (according to their economic characteristics) which make up the financial statements. These elements are grouped under two headings, namely the elements that pertain to the financial position in the balance sheet (statement of financial position) namely assets, liabilities and equity and the elements that pertain to the financial performance in the income statement (statement of profit or loss and other comprehensive income) namely income and expenses. The statements used to reflect changes in the financial position (statement of changes in equity and the cash flow statement (statement of cash flows) reflect income statement (statement of profit or loss and other comprehensive income) and balance sheet (statement of financial position) elements and therefore the Conceptual Framework does not identify any specific elements for these statements. It must be noted that the Conceptual Framework only specifies and defines the elements pertaining to financial statements, and does not venture into the actual composition (layout) of the financial statements. This is done by IAS 1, which is discussed in paragraph 1.4. 1.2.6.2 Financial position (balance sheet) (statement of financial position) The elements that are directly related to the financial position are assets, liabilities and equity (Conceptual Framework .4.4). 12 About Financial Accounting: Volume 2 (a) Assets An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. According to paragraph 4.8 of the Conceptual Framework, the future economic benefit embodied in an asset is the potential to contribute directly or indirectly to the flow of cash and cash equivalents to the entity. Paragraph 4.10 explains that the future economic benefit embodied in an asset may flow to the entity in a number of ways. For example, an asset may be used singly or in combination with other assets in the production of goods or services to be sold by the entity, exchanged for other assets, used to settle a liability, or distributed to the owners of the entity. The physical form of the asset is not essential to the existence of an asset, for example property, plant and equipment can be physically identified whilst patents and copyright, which only exist on paper, are also assets if future economic benefits are expected to flow from them to the entity and if they are controlled by the entity (Conceptual Framework .4.11). The Conceptual Framework 4.14 states that there is a close association between incurring expenditure and generating assets, but that the two do not necessarily coincide. When an entity incurs expenditure, this may provide evidence that future economic benefits were sought, but is not conclusive proof that an item satisfying the definition of an asset has been obtained. Similarly, the absence of a related expenditure does not preclude an item from satisfying the definition of an asset and thus becoming a candidate for recognition in the balance sheet (statement of financial position), for example, items that have been donated to the entity may satisfy the definition of an asset. (b) Liabilities Paragraph 4.15 of the Conceptual Framework states that an essential characteristic of a liability is a present obligation. An obligation is a duty or a responsibility to act or perform in a certain way. A future commitment, for example a decision by management to acquire assets in the future does not, in itself, give rise to a present obligation and is not regarded as a liability because there is no past transaction resulting in a present obligation. An obligation normally arises only when the asset is delivered or the entity enters into an irrevocable agreement to acquire the asset (Conceptual Framework .4.16). According to paragraph 4.17 of the Conceptual Framework, the settlement of a present obligation usually involves the entity giving up resources embodying economic benefits in order to satisfy the claim of the other party. Settlement of obligations may occur in a number of ways, for example by payments in cash, transfer of other assets, provision for services, replacement of that obligation with another obligation, and conversion of the obligation to equity or any other means, for example a creditor waiving or forfeiting its rights. Liabilities result from past transactions or other past events. Thus, for example, the acquisition of goods and the use of services give rise to trade payables (unless paid in advance or on delivery) and the receipt of a bank loan results in an obligation to repay the loan (Conceptual Framework .4.18). Chapter 1: Introduction to the preparation and presentation of financial statements 13 (c) Equity Equity is the residual interest in the assets of the entity after deducting all liabilities (Conceptual Framework .4.4). If it is to the benefit of users, equity can be subclassified in the balance sheet (statement of financial position) in order to improve understandability (Conceptual Framework .4.20). The amount at which equity is shown in the balance sheet (statement of financial position) is dependent on the measurement of assets and liabilities. Paragraph 4.22 of the Conceptual Framework states that it is normally only by coincidence that the aggregate amount of equity corresponds with the aggregate market value of shares of the entity or the sum that could be raised by disposing of either the net assets on a piecemeal basis, or the entity as a whole on a piecemeal basis. The Conceptual Framework .4.23 clearly states that commercial, industrial and business activities are often undertaken by means of entities such as sole proprietors, partnerships and trusts of the entities and various types of government business undertakings. The legal and regulatory framework for such entities is often different from that of the entities applying to corporate entities. For example, there may be few, if any, restrictions on the distribution to owners or other beneficiaries of amounts included in equity. Nevertheless, the definition of equity and the other aspects of this Conceptual Framework that deal with equity are appropriate for such entities. 1.2.6.3 Financial performance (income statement) (statement of profit or loss and other comprehensive income) In paragraph 4.24, the Conceptual Framework specifically notes that profit is frequently used as a measure of performance or as the basis for other measures such as return on investments or earnings per share. The elements directly related to the measure of profit are income and expenses. The recognition and measurement of income and expenses, and hence profit, depends in part on the concept of capital and capital maintenance used by the entity in preparing financial statements (refer to 1.2.10). The elements that are directly related to the financial performance are defined as follows: (a) Income Income is an increase in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity other than those relating to the contributions from the equity participants (Conceptual Framework .4.25). The definition of income encompasses both revenue and gains. Revenue arises in the course of the ordinary activities of an entity and is referred to by a variety of different names including sales, fees, interest, dividends, royalties and rent (Conceptual Framework .4.29). Gains represent other items that meet the definition of income and may or may not arise in the course of ordinary business activities, for example profit made on the sale of obsolete non-current assets. As gains result in an increase in economic benefit, the result is the same as that of income and is therefore not classified as a separate element. The Conceptual Framework (.4.31) states that gains are reported net of related expenses and when gains are recognised in the income 14 About Financial Accounting: Volume 2 statement (statement of profit or loss and other comprehensive income), they are reported separately because knowledge of their existence can be useful in making economic decisions. (b) Expenses The Conceptual Framework (.4.25) defines expenses as decreases in economic benefits during the accounting period in the form of outflows or depletion of assets or incurrence of liabilities that result in decreases in equity, other than those relating to a distribution to equity participants. The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the entity. The latter types of expenses usually take the form of an outflow of cash or depletion of assets such as property, plant and equipment and include such items as cost of sales, salaries and wages, and depreciation (Conceptual Framework .4.33). Losses represent decreases in economic benefit that may, or may not, arise in the course of the ordinary activities of the business, for example a loss on the sale of a non-current asset. As losses result in a decrease in economic benefits, the result is the same as that of expenses and is therefore not classified as a separate element (Conceptual Framework .4.34). Losses are reported net of related income and when losses are recognised in the financial statements, they are reported separately because knowledge of them is useful for making economic decisions (Conceptual Framework .4.35). 1.2.7 Recognition of the elements of financial statements Recognition is the process of incorporating an item that meets the definition of an element and satisfies the criteria for recognition in the balance sheet (statement of financial position) or income statement (statement of profit or loss and other comprehensive income). It involves the depiction of the item in words and in monetary value (as an amount) and the inclusion of that amount in the balance sheet (statement of financial position) or income statement (statement of profit or loss and other comprehensive income) totals. Items that satisfy the recognition criteria should be recognised in the balance sheet (statement of financial position) or income statement (statement of profit or loss and other comprehensive income). The failure to recognise such items is not rectified by disclosure of the accounting policies used nor by notes or explanatory material (Conceptual Framework .4.37). In practice, this means that an item must first be recorded in the journals and ledgers before it can be incorporated in the financial statements. According to the Conceptual Framework (.4.38), “an item that meets the definition of an element should be recognised if: (a) It is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) The item has a cost or value that can be measured with reliability.” Probability refers to the degree of uncertainty that the future economic benefits associated with the item will flow to or from the entity (Conceptual Framework .4.40). An example is sales on credit. The possibility that not all the trade debtors will pay their outstanding accounts is highly likely, therefore an expense (by way of providing for Chapter 1: Introduction to the preparation and presentation of financial statements 15 credit losses), representing the expected reduction in economic benefit, is recognised. If no cost or value can be attached to an item, and it is also not possible to make a reasonable estimate of its cost or value, such an item cannot be recognised in the balance sheet (statement of financial position) or income statement (statement of profit or loss and other comprehensive income), but can still be disclosed in the notes to the financial statements if the disclosure thereof may influence the decisions of the users of those financial statements (Conceptual Framework .4.41). An example of this would be a pending law suit against the entity which has not been recognised because the financial impact on the entity can’t be estimated reliably. More specifically, the Conceptual Framework (.4.44–.4.53) lays down the following criteria for the recognition of each element of the financial statements: l Assets: An asset is recognised in the balance sheet (statement of financial position) when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably (Conceptual Framework .4.44). If however the expenditure has been incurred for which it is considered improbable that economic benefit will flow to the entity beyond the current accounting period, an asset is not recognised in the balance sheet (statement of financial position) but it is recognised as an expense in the income statement (statement of profit or loss and other comprehensive income) (Conceptual Framework .4.45). l Liabilities: A liability is recognised in the balance sheet (statement of financial position) when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably (Conceptual Framework .4.46). l Income: Income is recognised in the income statement (statement of profit or loss and other comprehensive income) when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. This means, in effect, that recognition of income occurs simultaneously with the recognition of increases in assets or decreases in liabilities, for example merchandise sold for cash (Conceptual Framework .4.47). l Expenses: Expenses are recognised in the income statement (statement of profit or loss and other comprehensive income) when a decrease in future economic benefits related to a decrease in an asset or an increase in a liability has arisen that can be measured reliably. This means, in effect, that recognition of expenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in assets (Conceptual Framework .4.49). Expenses are recognised in the income statement (statement of profit or loss and other comprehensive income) on the basis of direct association between the costs incurred and the earning of specific items of income. This process, commonly referred to as the “matching of costs with revenues”, involves the simultaneous or combined recognition of revenue and expenses that result directly and jointly from the same transaction, for example matching the cost of sales with the income derived from the sale of those goods (Conceptual Framework .4.50). When economic benefits are 16 About Financial Accounting: Volume 2 expected to arise over several accounting periods and the association with income can only be broadly or indirectly determined, expenses are recognised in the income statement on the basis of systematic and rational allocation procedures, for example depreciation on non-current assets. These allocation procedures are intended to recognise expenses in the accounting periods in which the economic benefits that are associated with these items are consumed or have expired (Conceptual Framework .4.51). Paragraph 4.52 of the Conceptual Framework states clearly that an expense is recognised immediately in the income statement (statement of profit or loss and other comprehensive income) when an expenditure produces no future economic benefits or when and to the extent that, future economic benefits do not qualify, or cease to qualify, for recognition in the balance sheet (statement of financial position) as an asset. An expense is also recognised in the income statement (statement of profit or loss and other comprehensive income) in those cases when a liability is incurred without the recognition of an asset, for example when a liability under a product warranty arises (Conceptual Framework .4.53). 1.2.8 Measurement of the elements of financial statements “Measurement” is defined as the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet (statement of financial position) and income statement (statement of profit or loss and other comprehensive income) (Conceptual Framework .4.54). The Conceptual Framework lists four bases of measurement: historical cost, realisable value, current cost, and present value. Although the historical cost is the measurement basis most commonly adopted by entities, it is usually combined with other measurements bases, for example, inventories are usually carried at the lower of cost and net realisable value, and property, plant and equipment are reported at their historical cost or revalued (present value) amounts. The Conceptual Framework describes the four measurement bases as follows (Conceptual Framework .4.55): l Historical cost means that assets are recorded at the amount of cash or cash equivalent paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation or at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business. The drawback of this approach is its inability to deal with the effect of changing prices of non-monetary assets, with the result that some entities prefer the current cost model to measure the elements of the balance sheet (statement of financial position) and income statement (statement of profit or loss and other comprehensive income). l Realisable value (settlement value) means that assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the assets in an orderly disposal. Liabilities are carried at their settlement values, i.e. the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business. Chapter 1: Introduction to the preparation and presentation of financial statements 17 l Current cost means that assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligations currently. l Present value means that assets are carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business. Although the Conceptual Framework does not mention fair value as a measurement basis, IAS 1.109 states fair value to be a measurement basis. The Conceptual Framework is not an IFRS and does not override the requirements of a Standard and hence fair value is regarded as a measurement basis. Fair value is defined as the amount for which an asset could be sold or a liability transferred between market participants on the measurement date (IAS 32.11). 1.2.9 The concepts of capital and capital maintenance The Conceptual Framework .4.57 to .4.65 describes two concepts of capital and capital maintenance, namely the financial concept and the physical concept. 1.2.9.1 The concepts of capital Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity, and is adopted in cases where the users of financial statements are primarily concerned with the maintenance of nominal invested capital or the purchasing power of invested capital. Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the entity based on, for example, units of production per day. The selection of the appropriate concept of capital by an entity should be based on the needs of the users of its financial statements. According to the Conceptual Framework (.4.58) a financial concept of capital should be adopted if the users of financial statements are primarily concerned with the maintenance of nominal invested capital or purchasing power of invested capital. If the main concern of users is with the operating capability of the entity, a physical concept of capital should be used. The concept chosen indicates the goal to be attained in determining profit. 1.2.9.2 The concepts of capital maintenance and the determination of profit The Conceptual Framework (.4.59) states that the concepts of capital give rise to the following two concepts of capital maintenance (a) Financial capital maintenance Under this concept a profit is only earned if the financial amount of the net assets at the end of the period exceeds the financial amount of the net assets at the beginning of the period, after excluding any distributions to and contributions from owners during the period. 18 About Financial Accounting: Volume 2 (b) Physical capital maintenance Under this concept a profit is earned only if the physical productive capacity of the entity at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to and contributions from owners during the period. According to the Conceptual Framework (.4.65), the selection of a measurement basis and concept of capital maintenance will determine the accounting model used in the preparation of the financial statements. Different accounting models exhibit different degrees of relevance and reliability and, as in other areas, management must seek a balance between relevance and reliability. The Conceptual Framework is applicable to a range of accounting models and provides guidance on preparing and presenting the financial statements constructed under the chosen model. The Board of IASC has no present intention to prescribe a specific model other than in exceptional circumstances, such as under hyper-inflationary conditions, which fall outside the scope of this textbook. 1.3 The South African regulatory reporting framework 1.3.1 Introduction Before 2005 Statements of Generally Accepted Accounting Practise (GAAP) needed to be adhered to when preparing the financial statements of entities incorporated under the previous Companies Act (Act 61 of 1973) because this Companies Act, by way of paragraph 5 of Schedule 4, required this compliance with the Statements of GAAP. The fact that this compliance is not required by any other form of business ownership did not mean that the requirements of these statements cannot be applied when preparing the financial statements of forms of ownership other than companies. In South Africa it became common practice to apply these statements, to a certain extent, to other forms of business ownership, although there is no legal requirement that the financial statements of sole traders, partnerships and close corporations must comply with the Statements of GAAP. The problem was that the preparers of the financial statements of entities incorporated under another law (close corporations) or not incorporated at all (sole traders and partnerships) may purport that the financial statements were prepared to comply with the Statements of GAAP. Compliance with the Statements of GAAP meant compliance to all aspects of the standards. If this is not the case, then no statement to this effect can be made by the preparer of financial statements. South Africa adopted International Financial Reporting Standards (IFRS) in 2003. From 1 January 2005 South African Statements of GAAP comply with International Financial Reporting Standards (IFRSs). “IFRSs” are Standards and Interpretations adopted by the International Accounting Standards Board (IASB). They comprise the following: l International Financial Reporting Standards (deals with recognition, measurement, presentation and disclosure requirements in general purpose financial statements); l International Accounting Standards; (is a designated part of IFRSs) and l Interpretations originated by the International Financial Reporting Interpretations Committee (IFRIC) or the former Standing Interpretations Committee (SIC) (issues interpretations of IASs and provides guidance on the application of IFRSs). Chapter 1: Introduction to the preparation and presentation of financial statements 19 The relationship between South African Statements of GAAP and International Financial Reporting Standards is discussed in the next paragraph. 1.3.2 The current South African financial reporting framework From 1 January 2005, the Johannesburg Securities Exchange required that all listed companies had to comply with International Financial Reporting Standards (IFRSs).The Companies Act 71 of 2008, which came into effect on 1 May 2011, established a body known as the Financial Reporting Standards Council (FRSC). The FRSC replaced the APB and is now South Africa’s constituted governmental accounting standard setting body. For all financial periods commencing on or after 1 December 2012 all companies had to convert to IFRS or IFRS for SMEs (Small and Medium-sized Entities). The Companies Regulations of 2011 (Regulation 27) prescribes financial reporting standards applicable by category of company and is listed in table 1.1 below. Table1.1 Financial Reporting Standards applicable to category of company Category of company Financial Reporting Standard State-owned companies IFRS, but in the case of any conflict with any requirements in terms of the Public Finance Management Act, the latter prevails. Public companies listed on an exchange IFRS Public companies not listed on an exchange One of: (a) IFRS (b) IFRS for SMEs, provided that the company meets the scoping requirements outlined in the IFRS for SMEs. Profit companies, other than state-owned or public companies, whose public interest score for the particular financial year is at least 350 One of: (a) IFRS (b) IFRS for SMEs, provided that the company meets the scoping requirements outlined in the IFRS for SMEs. Profit companies, other than state-owned companies: (a) whose public interest score for the particular financial year is at least 100 but less than 350; or One of: (a) IFRS (b) IFRS for SMEs, provided that the company meets the scoping requirements outlined in the IFRS for SMEs; or (b) whose public interest score for the particular financial year is less than 100, and whose statements are independently compiled. (c) IFRS for SMEs Profit companies, other than state-owned companies or public companies, whose public interest score for the particular financial year is less than 100 and whose statements are internally compiled The Financial Reporting Standard as determined by the company for as long as no Financial Reporting Standard is prescribed. 20 About Financial Accounting: Volume 2 (Please note that the calculation of the public interest score falls outside the scope of this textbook.) 1.4 Presentation of financial statements (IAS 1) Overview of the presentation of financial statements (IAS 1) IAS 1: Presentation of Financial Statements Objective of IAS 1 Prescribes the basis of the presentation of general-purpose financial statements, sets out the overall requirements for the presentation of financial statements, provides guidelines for their structure and minimum requirements Purpose of financial statements Provides useful information to users and the result of management’s stewardship of the resources entrusted to them Overall considerations when preparing financial statements Fair presentation Going concern Accrual basis Materiality and aggregation Offsetting Frequency Comparative information Consistency of presentation Full set of financial statements continued Chapter 1: Introduction to the preparation and presentation of financial statements 21 Statement of Financial Position presenting Property, plant and equipment Investment property Intangible assets Financial assets Inventories Trade and other receivables Cash and cash equivalents Trade and other payables Financial liabilities Issued capital and reserves Statement of profit or loss and other comprehensive income presenting Revenue Finance costs Tax expenses Profit or loss Other comprehensive income Total comprehensive income Statement of changes in equity presenting Total comprehensive income Contributions and distributions by owners. For each component of equity, a reconciliation between the carrying amount at the beginning and end of the period Statement of cash flows presenting Generation of cash and cash equivalents Utilisation of cash and cash equivalents Notes to the financial statements presenting Information about the basis of preparation of the financial statements and the specific accounting policies applied Present information required by IFRS and not already presented somewhere else Supporting information for items presented in the financial statements Additional information for items not presented in the financial statements 1.4.1 Introduction The objective of IAS 1 is to prescribe the basis for the presentation of general-purpose financial statements to ensure comparability both with the entity’s financial statements of previous periods and with the financial statements of other entities. Remember that general-purpose financial statements are those intended to meet the needs of users 22 About Financial Accounting: Volume 2 who are not in a position to demand reports tailored to meet their particular information needs. To achieve this objective, IAS 1 sets out overall requirements for the presentation of financial statements, guidelines for their structure and minimum requirements for their content (IAS 1.1 to .3). IAS 1 uses terminology that is suitable for profit-orientated entities, including public sector business entities. Entities with not-for-profit activities in the private sector, public sector and government seeking to apply this standard can amend the descriptions used for particular line items in the financial statements and for the financial statements themselves (IAS 1.5). Similarly, entities that do not have equity and entities whose share capital is not equity, and entities whose equity does not consist of share capital, may need to adapt the presentation in the financial statements to members’ or unit holders’ interest (IAS 1.6). 1.4.2 Definitions IAS 1 .7 gives the following definitions of terms used in this Standard: General purpose financial statements (referred to as financial statements) are those intended to meet the needs of users who are not in a position to require an entity to prepare reports tailored to their particular information needs. Impracticable: Applying a requirement is impracticable when the entity cannot apply it after making every reasonable effort to do so. International Financial Reporting Standards (IFRSs) are Standards and Interpretations adopted by the International Accounting Standards Board (IASB). They comprise: (a) International Financial Reporting Standards; (b) International Accounting Standards; and (c) Interpretations developed by the International Financial Reporting Interpretations Committee (IFRIC) or the former Standing Interpretations Committee (SIC). Material: Omissions or misstatements are material if they could individually or collectively influence the economic decisions that users make on the basis of financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. Notes contain information in addition to that presented in the statement of financial position, statement of profit or loss and other comprehensive income, separate income statement (if presented), statement of changes in equity and statement of cash flows. Notes provide narrative descriptions or disaggregation of items presented in those statements and information about items that do not qualify for recognition in those statements. Other comprehensive income comprises items of income and expense that are not recognised in profit or loss as required or permitted by other IFRSs. The components of other comprehensive income include: (a) changes in revaluation surplus; (b) actuarial gains and losses on defined benefit plans; (c) gains and losses arising from translating the financial statements of a foreign operation; (d) gains and losses on remeasuring investments in equity instruments; Chapter 1: Introduction to the preparation and presentation of financial statements 23 (e) the effective portion of gains and losses on hedging instruments in a cash flow hedge. Owners are holders of instruments classified as equity. Profit or loss is the total of income less expenses, excluding the components of other comprehensive income. Total comprehensive income is the change in equity during a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners. It therefore comprises all components of “profit or loss” and of “other comprehensive income”. 1.4.3 The purpose of financial statements IAS 1 .9 describes financial statements as structured representations of the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic decisions. Financial statements not only provide information to users but also show the result of management’s stewardship of the resources entrusted to them. To meet its purpose, financial statements provide information about an entity’s: l assets; l liabilities; l equity; l income and expenses, including gains and losses; l other changes in equity; and l cash flows. The Standard observes that this information, along with other information in the notes, would assist users of financial statements in predicting the entity’s future cash flows and, in particular, their timing and certainty. According to IAS 1.10, a complete set of financial statements comprises: l a statement of financial position as at the end of the period; l a statement of profit or loss and other comprehensive income for the period; l a statement of changes in equity for the period; l a statement of cash flows for the period; and l notes, comprising a summary of significant accounting policies and other explanatory notes. 1.4.4 Overall considerations when preparing financial statements The overall consideration when preparing financial statements, as laid out in IAS 1, is more prescriptive than descriptive in nature. The use of the word “shall” strengthens the prescriptive nature of these considerations, which were also dealt with in the Conceptual Framework, but in a more descriptive way. 1.4.4.1 Fair presentation IAS 1 .15 states that the financial statements shall present fairly the financial position, financial performance and cash flows of an entity. Fair presentation requires the faithful 24 About Financial Accounting: Volume 2 representation of the effect of transactions, other events and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the Conceptual Framework. The application of the IFRSs, with additional disclosure when necessary, is presumed to result in financial statements that achieve a fair presentation. An entity whose financial statements comply with the IFRSs shall make an explicit and unreserved statement of compliance in the notes. Financial statements shall not be described as complying with the IFRSs unless they comply with all the requirements of the IFRSs (IAS 1.16). In practice, this means that if an entity complies with the requirements of IAS 1, but not with any of the other requirements of any of the other standards, it must be silent on expressing its compliance with IFRS. Paragraphs 19 to 24 of IAS 1 deal with the rare circumstances in which management of an entity concludes that compliance with a requirement in a Standard or an Interpretation would be so misleading that it would be in conflict with the objective of the financial statements, and prescribe the manner in which to present such a departure. The exact specifics fall outside the scope of this textbook. 1.4.4.2 Going concern IAS 1.25 reminds the preparer of financial statements that these statements shall be prepared on a going-concern basis unless there is an indication that the management of the entity intends to liquidate the entity or to cease trading, or has no other option but to do so. The preparation of financial statements other than for a going concern falls outside the scope of this textbook. 1.4.4.3 Accrual basis An entity shall prepare its financial statements, except cash flow information, using the accrual basis of accounting (IAS 1.27). When the accrual basis of accounting is used, items are recognised as assets, liabilities, equity, income and expenses (the elements of financial statements) when they satisfy the definitions and recognition criteria for those elements as set out in the Conceptual Framework (IAS 1.28). 1.4.4.4 Materiality and aggregation According to IAS 1.29, each material class of similar items shall be presented separately in the financial statements. Items of dissimilar nature or function shall be presented separately, unless they are immaterial. This, in effect, means that similar items must be grouped together and presented as a class in the financial statements. Items that cannot be allocated to a specific class must be shown separately if they are material (refer to paragraph 1.4.2). Financial statements result from processing large numbers of transactions or events that are aggregated into classes according to their nature or function. The final stage in the process of aggregation and classification is the presentation of condensed and classified data, which form the line items on the face of the balance sheet (statement of financial position), income statement (statement of profit or loss and other comprehensive income), statement of changes in equity and cash flow statement (statement of cash flows), or in the notes. If a line item is not individually material, it is aggregated with other items on the face of those statements or in the notes. An item that is not sufficiently material to warrant separate presentation on the face of those Chapter 1: Introduction to the preparation and presentation of financial statements 25 statements may nevertheless be sufficiently material for it to be presented separately in the notes (IAS 1.30). 1.4.4.5 Offsetting Paragraph 32 of IAS 1 does not encourage offsetting. It states that assets and liabilities, and income and expenses, shall not be offset unless required or permitted by a Standard or an Interpretation. The exceptions are gains and losses on the disposal of non-current assets, investments and operating assets, which are reported by deducting from the proceeds on disposal, the carrying amount of the asset and related selling expenses. Measuring the assets net of valuation allowances, for example provision for credit losses and depreciation, or showing inventories at a lower value than their cost price, is not seen as offsetting (IAS 1.33 to .35). 1.4.4.6 Frequency of reporting A complete set of financial statements shall be presented at least annually. When an entity changes the end of its reporting period and the financial statements are presented for a longer or shorter period than one year, the entity must explain the reason for using a longer or shorter period. For example, a new entity that started trading during a financial year will only be able to report on its operations for a shorter period than a year. In such cases, the fact that amounts presented in the financial statements are not entirely comparable must also be mentioned (IAS 1.36). 1.4.4.7 Comparative information IAS 1.38 states that comparative information shall be disclosed in respect of previous periods for all amounts reported in the financial statements. Comparative information shall also be included for narrative and descriptive information when it is relevant to an understanding of the current period’s financial statements. In this volume, however, comparative information, except where it is absolutely necessary for the purpose of an explanation or calculation, is omitted, as the use of comparative figures does not facilitate the learning process. 1.4.4.8 Consistency of presentation The presentation and classification of items in the financial statements shall be retained from one period to the next (IAS 1.45). An entity changes the presentation of its financial statements only if the changed presentation provides information that is reliable, more relevant to the users of the financial statements and the revised structure is likely to continue, so that comparability is not impaired (IAS 1.46). 1.4.5 Structure and contents of financial statements 1.4.5.1 Introduction IAS 1.47 requires particular disclosures on the face of the statement of financial position, statement of profit or loss and other comprehensive income and statement of changes in equity and requires disclosure of other line items either on the face of those statements or in the notes. With regard to the statement of cash flows, requirements regarding disclosure in this statement are set out in IAS 7, which deals with the statement of cash flows (refer to Chapter 6). 26 About Financial Accounting: Volume 2 1.4.5.2 Identification of financial statements IAS 1.51 to .53 require that each component of the financial statements shall be identified clearly so that the users can easily distinguish them from other information supplied in financial reports. In addition, the following information shall be displayed prominently and repeated when it is necessary for a proper understanding of the information presented: l the name of the reporting entity; l the date at the end of the reporting period or the period covered by the set of financial statements or notes; l the presentation currency; l the level of rounding used in presenting amounts in the financial statements. For the purpose of this volume, only applicable information for an introductory course in accounting is listed. 1.4.5.3 Statement of financial position As a minimum, the statement of financial position shall include line items that present the following amounts: IAS 1.54 (only those items applicable to this volume are mentioned): l property, plant and equipment; l investment property; l intangible assets; l financial assets (for example an equity instrument of another entity held for investment purposes or a cash investment); l inventories; l trade and other receivables; l cash and cash equivalents; l trade and other payables; l financial liabilities (for example a contractual obligation to deliver cash or another financial asset to another entity or to exchange financial assets or financial liabilities under conditions that are potentially unfavourable to the entity); l issued capital and reserves. IAS 1.55 to .57 further state that an entity shall present additional line items, headings and subtotals in the statement of financial position when such presentation is relevant to an understanding of the entity’s financial position. These line items are included when the size, nature or function of an item or aggregation of similar items is such that separate presentation is relevant to an understanding of the entity’s financial position. An entity shall present current and non-current assets, and current and non-current liabilities as separate classifications in the statement of financial position (IAS 1.60). (a) Current assets According to IAS 1.66, an asset shall be classified as “current” when it satisfies any of the following criteria: l it is expected to be realised in, or intended for sale or consumption in the entity’s normal operating cycle; l it is held primarily for the purpose of being traded; Chapter 1: Introduction to the preparation and presentation of financial statements 27 l it is expected to be realised within twelve months after the reporting period; or l it is cash or a cash equivalent, unless it is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period. IAS 1.68 explains the operating cycle of an entity as the time between the acquisition of assets for processing and their realisation in cash or cash equivalents. When the entity’s normal operating cycle is not clearly identifiable, its duration is assumed to be twelve months. Current assets include assets (such as inventories and trade receivables) that are sold, consumed or realised as part of the normal operating cycle, even when they are not expected to be realised within twelve months after the reporting period. Current assets also include assets held primarily for the purpose of being traded (financial assets held for trading) and the current portion of non-current financial assets. All other assets that do not conform to the above criteria shall be classified as “noncurrent assets” and include tangible, intangible and financial assets of a long-term nature. This Standard does not prohibit the use of alternative descriptions as long as the meaning is clear (IAS 1.57), for example the term “fixed assets” could be used in place of “non-current assets”. For the purpose of this textbook (both volumes), the terminology of this Standard is preferred and used. (b) Current liabilities A liability shall be classified as “current” when it satisfies any of the following criteria (IAS 1.69): l it is expected to be settled in the entity’s normal operating cycle; l it is held primarily for the purpose of being traded; l it is due to be settled within twelve months after the balance sheet (statement of financial position) date; or l the entity does not have an unconditional right to defer settlement of the liability for at least twelve months after the balance sheet (statement of financial position) date. All other liabilities that do not conform to the above criteria shall be classified as “noncurrent liabilities”. Some current liabilities, such as trade payables and some accruals for employee and other operating costs, are part of the working capital used in the entity’s normal operating cycle. Such operating items are classified as current liabilities even if they are to be settled more than twelve months after the reporting period. The same normal operating cycle applies to the classification of an entity’s assets and liabilities. When the entity’s normal operating cycle is not clearly identifiable, its duration is assumed to be twelve months (IAS 1.70). Some current liabilities are not settled as part of the normal operating cycle, but are due for settlement within twelve months after the reporting period. Examples given by this Standard are a bank overdraft, the current portion of non-current financial liabilities, dividends payable, income taxes and other non-trade payables. Financial liabilities that provide financing on a long-term basis (i.e. must not be part of the working capital used in the entity’s normal operating cycle) and are not due for settlement within twelve months after the reporting period, are non-current liabilities (IAS 1.62).