WEEK 3a: CONCEPTS, CONVENTIONS, DEFINITIONS

1. A cash basis; and

2. An accruals basis 

*11k loss divided by 5 as this is the cost of the machine divided by how many years it is used for regardless of how much they actually paid in that first year.

The accruals concept serves to ‘smooth – out’ the cost over the several periods during which the cost is incurred (consumed). You are matching the expense to the revenues the machine generated (matching concept).

The annual charge against each successive years profits is known as the depreciation charge. This is but one example of ‘accruals’ being implemented.

1.2 The consistency concept

We have seen from the above that machinery (and certain other ‘assets’) must be subject to depreciation (that is the original cost gets ‘spread’ across the lifetime of the asset).

But there are several ways of achieving this, for example:

1. the straight line method (as above); or

2. the reducing balance method

Each way is known as a basis. When a particular basis is selected by a firm becomes an accounting policy of that firm.

The consistency concept dictates that:

• Accounting policies must be adhered to year-on-year

• Policies should not be changed without good reason

• Such changes must be disclosed to shareholders in the annual report and accounts

1.3 The ‘going concern’ concept

This ‘concept’ is (in effect) an assumption. We assume that the business is going to continue to survive and prosper (i.e. it is a ‘going concern’) unless the contrary is known to be true. The significance of this is as follows:

Whist the going concern assumption is correct:

The entity is not about to be liquidated; therefore:

Historic cost values can continue to be used (a practice in itself known as the cost concept). Most assets in the balance sheet are measured at cost (less depreciation), as opposed to any other basis of measurement.

If the going concern assumption is not correct, the current market value would have to be used, because the business is about to be wound-up.

1.4 The Prudence Convention

In the ideal world the true value of income and assets can be accurately assessed and measured. In the real world there are problems of measurement; often there is more than one basis by which to value certain items and transactions.

Prudence is the inclusion of a degree of caution in the exercise of judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not over-stated, and liabilities or expenses are not under-stated.

In simpler terms this means being cautious not to overestimate your incomes or underestimate your loans/ debts.

2. The ‘qualitative characteristics’ of financial statements

Identified in the conceptual framework published by the IASB (hereafter referred to as The Framework, these are desirable elements. In other words ‘good’ financial reporting information should possess the following:

2.1 Understandability

The information provided should be readily understandable by users having a reasonable knowledge of business and economic activities and accounting, and a willingness to study the information with reasonable diligence.

As an exercise students might like to make a simple web-search for the latest annual report and accounts of a major plc, and assess for themselves how much of the accounts they understand.

2.2 Relevance

Information has this characteristic when it influences the economic decisions of users by helping them evaluate past, present or future events or conforming, or correcting their past evaluations

Materiality is considered a sub-attribute of relevance. i.e. it is a threshold point below which relevance does not exist. Information is material if its omission or-mis-statement could influence the economic decisions of users.

In simpler terms information helps people make decisions and materiality is a specific part of relevance that states if the information could impact a decision then it is considered material and relevant.

2.3 Reliability

Information has this characteristic if it is free from material error and bias and can be depended upon to represent faithfully that which it either purports to represent or could reasonably be expected to represent.

Substance over form, neutrality, prudence and completeness are also cited as sub-characteristics of this characteristic.

Note the inclusion of substance over form – this is a key feature if The Framework and the principle lies at the heart of several of international standards – notably IAS17: Leases and IAS32 concerning Financial Instruments.

2.4 Comparability

It should be possible to make comparison with previous accounting periods, or with the accounts of different entities (companies). Consequently the users should be informed of the accounting policies employed and of any changes to the policies, and of the effects of such changes.

3. The ‘elements’ of financial statements

Another section of The Framework defines assets and liabilities (amongst other elements). These definitions will help our understanding of Balance Sheets later on in the module:

3.1 Assets

3.1.1 The Framework definition of assets

“An asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to arise”.

A simple example:

A firm buys a new machine for £30,000 on credit. The machine is expected to reduce the costs of production of its only product by £50 per unit.

Is the resource controlled by the firm? Yes

Is this control as a result of a past event?. Yes

Future economic benefits? Yes - therefore it is an asset.

1. ‘Recognition’ of assets

Even when an asset meets the definition, it may still not meet the criteria for recognition in the balance sheet.

Will flow to the enterprise and the asset has a cost or value that can be measured reliably.

Is it probable (anything over 50%) that future economic benefits will flow from the machine? Yes

Can the cost be measured reliably? Yes (£30k)

Other examples of assets: if the firm has purchased (either for cash or on credit):

• Premises

• IT equipment

• Stock

• Cash and money in the bank are also assets

3.1.3. Intangible assets

All of the above are examples of tangible assets, because they can be ‘touched’ i.e. they have a physical presence.

But there are other ‘assets’ that have no such physical presence, known as intangibles.

There follows an extract from the Statement of Financial Position of WPP plc as at 31.12.2016:

                              £m

Goodwill & Intangible assets                              6,549.9

Property Plant and Equipment                                415.3

Other non-current assets (mainly investments)      767.1

Total non-current assets                                       7,732.3       

As you can see, goodwill and intangibles account for 84.7% of the non-current assets recognised on the company balance sheet.

The commercial world has undergone significant change over the last few decades. There has been increasing awareness of the potential (and innate value) of creating brand loyalty in consumers. These days it is not unusual for a firm to be ‘bought-out’ by another primarily for the prestige brand names in its ‘portfolio’. Famously, the Nestle takeover over Rowntree was motivated by the strength of the Rowntree Brands (such as Kit-Kat). The price paid by the acquiring firm is often far higher than the fair value of the assets of the new ‘subsidiary’. Part of this premium is referred to as goodwill. Some expenditure on computer software and web-site development creates future economic benefits, as does some expenditure on research and development into new products and processes, and on acquiring the associated intellectual property (I.P.) rights.

Understandably this has resulted in managers wanting to account for their ‘assets’ and for the extra value that appears to exist within their company. The main debate has centered on whether such expenditure should be:

    ß

• Written off (treated as an expense)

OR

•  Capitalised (treated as an asset)

In other words does the money spent constitute a

Expense or an investment?

And in other words still, does it constitute

Cost or an investment?

The international accounting standard covering what may and may not be classed as an intangible asset is IAS38: Intangible Assets.

Definition of an intangible asset

IAS38: Intangible Assets further gives us the following:

A non-monetary asset without physical substance.

It also stipulates that for intangibles to appear on the balance sheet they must be:

ß

Identifiable

Controlled (as a result of a past event)

The cost of the asset can be measured reliably

Which of the following qualify as intangible assets?

• ‘I.P.’ rights, franchise agreements  - yes, identifiable, controlled.

• Specialist staff skills - not normally - no 'control' over the future actions of staff

but there are exceptions: e.g.

• Football platers bought - the registration is the asset not the player

• But not 'home grown' players (cost cannot be measured)

Which of the following qualify as intangible assets?

• What about a portfolio of customers or market share – are these intangible assets?

No control over customers future actions (e.g. Ratner's jewelry)

• What about goodwill, brand names?

Only if bought from another company (otherwise cost cannot be measured)

• Research and development costs 

Research - No

Development - Yes if certain criteria are met

3.2 Liabilities

3.2.1. Definition (from the framework)

3.2.1 Definition of a liability

The current IASB definition, adopted in 2001, is enshrined in “The Framework” as follows:

“a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits”

Degrees of certainty of types of liability

There are different degrees of certainty attached to different types of liability. Uncertainty may attach to amount or to timing. The most certain – e.g. trade creditor, bank overdraft, loan – have a clearly defined monetary value, (evidenced by an invoice, borrowing agreement etc).

Bills not received are slightly less certain – for example an estimate of the value of utility bill not received till after the balance sheet date. But there is information available on which the estimate can be based (e.g. last years’ bill), and the date when the obligation falls due can be readily determined.

Degrees of certainty:

• Most certain - trade creditor, bank loan

• Bills not received - estimate required

• Provisions - much less certainty

The main problems arise relative to provisions, where there is less than 100% certainty about either amount or timing or both.

1. Provisions

Definition of a provision

• This is given in IAS37 thus: ß

• "a liability uncertain of timing or amount" 

• i.e. provisions are a ‘sub-set’ of liabilities.

3.2.     Recognition of a provision

IAS37 requires that a provision should only be recognised when all of the following conditions are met:

• There is a present obligation (legal or constructive) as a result of a past event

• It is probable that an outflow of resource is required to settle the obligation

• A reliable estimate can be made of the amount of the obligation

Taking each of these in turn:

3.2.1. Present obligation (legal or constructive) as a result of a past event

• Legal obligation – contractual

• ‘Constructive’ obligation – (by an established pattern of past practice, published policies or specific statements of intent) examples: ß

• 'Habitual' refunds, contamination clean-ups 

As a result of a ‘past event’:

This is likely to be the entering into of a contract, or an action that creates valid expectations in other parties.

3.2.1.1. Lawsuits pending - a special case

IAS37 recognises that there are rare circumstances, such as law-suits, where it is not clear whether a past event is deemed to give rise to a present obligation. In such cases a past event is deemed to give rise to a present obligation if, taking account of all available evidence (including, for example, the opinion of experts) it is more likely than not that a present obligation exists at the balance sheet date.

3.3. Provisions for re-structuring

The ‘Big Bath’ provision – (worked example):

Below are the hypothetical earnings of two companies over a three year period:

Both plc’s earn a total of £1.5bn over the three years. As a potential investor (as at the end of year 3) you might be attracted to the higher year three profits of DEF plc, but discouraged by the seemingly erratic nature of returns. The steady growth pattern of ABC might be a little more to your risk-averse tastes.

The creation (or increase) of a provision involves reducing the reported profit, whereas reducing a provision in effect ‘releases’ an amount equivalent to the reduction to be added back onto profit.

Suppose that in year 1 the Board of DEF plc decide to make a provision for ‘re-structuring costs’ of £300m. In year 2 they decide there is no longer a need for such re-structuring and the provision is released back onto the income statement. This would affect the DEF plc earnings as follows: ß

As you can see DEF plc now shows healthy Y2 profits and steady growth.

Now suppose that the company had no intention (in year 1) to re-structure – instead the intent was to smooth – out the earnings pattern (in other words the firm could foresee the down-turn in year 2). Such manipulation of earnings became known as the ‘big-bath’ provision. Clearly there was need for a standard stating precisely when a provision may and may not be recognised. That standard is IAS37. Under IAS37 re-structuring is a programme that is planned and is controlled by management and materially changes either:

The scope of business; or

The manner in which that business is conducted

The following are provided as examples of events that may fall under the definition of re-structuring:

• The sale or termination of a line of business

• The closure or re-location of business activities

• Changes in management structure (e.g. de-layering)

• Fundamental re-organisations that have a material effect on the nature and focus of operations.

The question is whether or not an enterprise has an obligation as at the balance sheet date. For such an obligation to exist: ß

• There must be a detailed plan  for the re-structuring; AND

• There must be a valid expectation (among those affected) that such a plan will be implemented – e.g. detailed plans have been announced or implementation will already have commenced.

The effect of these stipulations is to restrict the ability of the entity to make provisions. There has to be a past event that makes the transfer of benefits inescapable. The entity may not make “what if?” provisions when no such past event has occurred.