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CPA PROGRAM

FINANCIAL REPORTING 4TH EDITION MODULE 1

Published by Deakin University, Geelong, Victoria 3217, on behalf of CPA Australia Ltd, ABN 64 008 392 452 First edition published January 2010, updated July 2010, updated January 2011, reprintedJuly2011, updatedJanuary 2012, reprinted July 2012, updated January 2013, revisededitionJanuary 2013, reprinted July 2013, updated January 2014, revised edition January 2015, updated July 2015, updated January 2016 Third edition published November 2016 Fourth edition published January 2018 © 2010–2018 CPA Australia Ltd (ABN 64 008 392 452). All rights reserved. This material is owned or licensed by CPA Australia and is protected under Australian and international law. Except for personal and educational use in the CPA Program, this material may not be reproduced or used in any other manner whatsoever without the express written permission of CPA Australia. All reproduction requests should be made in writing and addressed to: Legal, CPA Australia, Level 20, 28 Freshwater Place, Southbank, VIC 3006, or [email protected]. Edited and designed by DeakinCo. Printed by Blue Star Print Group ISBN 978 1 921742 85 9

Authors Nikole Gyles Australian Accounting Standards Board (AASB) Janice Loftus University of Adelaide Carmen Ridley Australian Financial Reporting Solutions Dean Hanlon Monash University CPA Australia would also like to acknowledge the contribution of Catherine Pozzi and earlier contributions from Phil Hancock and Michael Jones. 2018 updates Karyn Byrne Sorin Daniluc Nikole Gyles Dean Hanlon John Kidd Janice Loftus Alex Martin Tiffany Tan Helen Yang

Consultant Australian National University Australian Accounting Standards Board (AASB) Monash University Consultant University of Adelaide ANZ Consultant Victoria University

Advisory panel Peter Gerhardy Shan Goldsworthy Kris Peach Daen Soukseun Themin Suwardy Anne Vuong Mark Shying Ram Subramanian David Hardidge

Ernst & Young Shans Accounting Services KPMG Department of Transport, Planning and Local Infrastructure, Victoria Singapore Management University National Australia Bank CPA Australia CPA Australia Telstra

CPA Program team Neha Abat Yvette Absalom Nicola Drury Freia Evans Kristy Grady

Kellie Hamilton Alex Lawrence Caroline Lewin Elise Literski Sarah Scoble

Educational designers Deborah Evans and Jane Latchford

Shari Serjeant Alisa Stephens Sarah Yang-Spencer Belinda Zohrab-McConnell

DeakinCo.

Acknowledgments This publication contains copyright material of the IFRS Foundation® in respect of which all rights are reserved. Reproduced by DeakinCo. with the permission of the IFRS Foundation. No permission granted to third parties to reproduce or distribute. For full access to IFRSStandards and the work of the IFRS Foundation please visit http://eifrs.ifrs.org. The International Accounting Standards Board, the IFRS Foundation, the authors and the publishers do not accept responsibility for any loss caused by acting or refraining from acting inreliance on the material in this publication, whether such loss is caused by negligence or otherwise. This publication contains copyright material from the Australian Securities and Investments Commission (ASIC). © Australian Securities andInvestments Commission. Reproduced with permission. ASIC’s regulatory advice is subject to change. For ASIC’s current regulatory advice and regulatory publications, please visit www.asic.gov.au/regulatory-resources. These materials have been designed and prepared for the purpose of individual study and should not be used as a substitute for professional advice. The materials are not, and are not intended to be, professional advice. The materials may be updated and amended from time to time. Care has been taken in compiling these materials, but they may not reflect the most recent developments and have been compiled to give a general overview only. CPA Australia Ltd and Deakin University and the author(s) of the material expressly exclude themselves from any contractual, tortious or any other form of liability on whatever basis to any person, whether a participant in this subjector not, for any loss or damage sustained or for any consequence that may be thought to arise either directly or indirectly fromreliance on statements made in these materials. Any opinions expressed in the study materials for this subject are those of the author(s) and not necessarily those of their affiliated organisations, CPA Australia Ltd or its members.

FINANCIAL REPORTING

Module 1 THE ROLE AND IMPORTANCE OF FINANCIALREPORTING

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Contents MODULE 1

Preview

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Introduction Objectives Teaching materials Information to CPA Program candidates studying FinancialReporting 2017 International Financial Reporting Standards—the Red Book Rounding

The role and importance of financial reporting

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The role of financial reporting The importance of financial reporting What are the different types of financial reporting for users? Understanding the International Financial Reporting Standards Non-International Financial Reporting Standards reporting Limitations of general purpose financial reporting Who must prepare general purpose financial reports? Interactionbetween financialreporting and the regulatoryenvironment International initiatives to decrease financial reporting complexity

The Conceptual Framework for FinancialReporting

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The purpose and application of the Conceptual Framework Principles established in the Conceptual Framework

Qualitative characteristics of useful financialinformation

28

Fundamental qualitative characteristics Enhancing qualitative characteristics The cost constraint on useful financial reporting Application of qualitative characteristics in the International Financial Reporting Standards

The elements of financial statements

35

Defining the elements of financial statements Criteria for recognising elements of financial statements Constraints on frameworks

Measurement of elements of financialstatements

40

Valuation techniques

Application of measurement principles in the International Financial Reporting Standards

55

Leases Employee benefits Accounting for share-based payments Investment property Professional judgment Disclosures

Review

76

Suggested answers

77

References

87

Optional reading

Module 1: The role and importance of financial reporting Study guide

Preview Introduction Financial reporting is the process of documenting an entity’s financial status in the form of financial reports/statements. The entity uses the prepared financial reports as a communication tool to assist users with their decision-making. Financial reports are accessed by a broad range ofusers, including shareholders, banks and other creditors, competitors, employees and financial analysts. Therefore, to assist users in their decision-making, it is critical that financial statements are prepared in accordance with a recognised financial reporting framework. The use of accounting standards as a consistent language for reporting ensures that financial statements are understandable and can be compared among entities. International Financial Reporting Standards (IFRSs) are the global language of accounting standards. This module considers the role and importance of financial reporting and discusses the application of reporting in an international context. It then discusses the need for general purpose financial statements (GPFSs) and the role that the Conceptual Framework for Financial Reporting (Conceptual Framework) plays in financial reporting. We also discuss the limitations of frameworks. In discussing the definitions and recognition criteria outlined in the Conceptual Framework, thismodule examines their application in IFRSs in the context of selected issues. Measurementis acomplex and controversial aspect of accounting. In this module, alternative measurement bases are studied, and the application of the mixed measurement model is examined. Measurement issues in relation to liabilities and expenses are considered in the context of leases,employee benefits and share-based payments. The module also explores the application of the ConceptualFramework inthe context of investment properties.

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MODULE 1

STUDY GUIDE |

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| THE ROLE AND IMPORTANCE OF FINANCIAL REPORTING

MODULE 1

Objectives After completing this module you should be able to: • explain the role and importance of financial reporting; • explain the role of the IASB Conceptual Framework in financial reporting and accountingstandards; • describe the objective and limitations of general purpose financial statements as identified inthe Conceptual Framework; • explain the definitions of the elements of financial statements and recognition criteria adopted by the Conceptual Framework; • explain the application of the standards to the financial reporting process and apply specificstandards; • discuss and demonstrate the importance of professional judgment in the financial reportingprocess; • explain the implications of using cost and fair value accounting; and • explain how materiality is assessed and determine the materiality of transactions.

Teaching materials International Financial Reporting Standards (IFRS), 2017 IFRS Standards (Red Book), and the followingInternational Accounting Standards (IASs): • IASB The Conceptual Framework for Financial Reporting (2010) • IFRS 2 Share-based Payment • IFRS 5 Non-current Assets Held for Sale and Discontinued Operations • IFRS 9 Financial Instruments • IFRS 13 Fair Value Measurement • IFRS 16 Leases • IAS 1 Presentation of Financial Statements • IAS 2 Inventories • IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors • IAS 16 Property, Plant and Equipment • IAS 19 Employee Benefits • IAS 36 Impairment of Assets • IAS 37 Provisions, Contingent Liabilities and Contingent Assets • IAS 40 Investment Property

Information to CPA Program candidates studying FinancialReporting Candidates enrolled in Financial Reporting will note that the IFRS’s (Red Book 2017) are used inthe study materials. All the relevant extracts from the IFRSs required for your study and exam purposes are presented in this study guide. It is not compulsory to access, print or purchase the IFRSs for your study or exam. Candidates who would like to explore the standards in more detail may consult the digital copy of the IFRSs, which is provided on My Online Learning inthe ‘Learning Resources and Additional Information’ folder. You can access the IFRSs from the website of the International Accounting Standards Board (IASB), but please note that the IFRSs on the website of the IASB’s website may not be aligned with the version of the IFRSs used in this edition of the Financial Reporting Study guide due to frequent amendments to the standards. The exam will cover the version of the standards used in the study guide, which are aligned with the Red Book 2017.

STUDY GUIDE |

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Throughout this subject, the accounting standards issued as at 1 January 2017 as presented in the 2017 Red Book are applied. The book is presented in two parts: • Part A includes the Conceptual Framework, as well as all of the accounting standards and interpretations as issued at 1 January 2017. • Note that the paragraph references for the Conceptual Framework start with the letters OB for Chapter 1 and QC for Chapter 3. • Part B includes all of the supporting documents for the Conceptual Framework accounting standards and interpretations as issued at 1 January 2017. These supporting documents include: – the basis of conclusions and, for some accounting standards, the dissenting opinions – implementation guidance – details of amendments and impacts on other accounting standards – illustrative examples.

Rounding In this subject, the questions and examples are sometimes rounded to the nearest dollar or thousands of dollars. In financial reporting, rounding is used in preparing financial statements, but any requirement to round is jurisdiction-specific and is not a requirement of the IFRSs. Inthissubject, where decimal places are used, all rounding should be to two decimal places unless otherwise stated.

The role and importance of financial reporting Financial reporting is a process that provides entities with an important communication tool allowing the management of an entity (preparers) to produce financial information for externalstakeholders (users). Financial statements are the key financial reporting tool that preparers use to communicate to users. Financial statements provide users with information about how an entity is being managed, including its financial position, financial performance andcash flows.

The role of financial reporting The role of financial reporting is to provide users with information to enable them to achieve effective decision-making. It also provides a stewardship or accountability role by requiring managers to give an account of how they have used the resources provided. Identification of the primary users of general purpose financial reports is crucial. The IASB categorises primary users as those that provide debt or equity to the entity. Specifically, theprimary users of an entity’s financial information are existing and potential investors, lendersand other creditors (Conceptual Framework, para. OB2). For example, investors may use financial statements to make decisions about when and how to invest their money, includingassessing how well the management of an entity has run the entity. Effective financial reporting communicates the ‘story’ of the entity during the period so that theusers can understand what the entity has achieved and how it has achieved it. Improving the communication effectiveness of financial statements is one of the central themes of the IASB’s standard-setting work (IFRS Foundation 2016a).

MODULE 1

2017 International Financial Reporting Standards—the Red Book

MODULE 1

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Financial reporting sits in a framework of other reporting provided by an entity. Other types of reporting include investor updates, sustainability reporting, corporate governance reporting and other prospective, or forward-looking, information. For example, when an entity is intending to list on a stock exchange, it would normally be required to provide some forward-looking information to potential investors to help them make their investment decision. Financial reports provide information about an entity’s financial position, and the effects of transactions and other events that give rise to changes in an entity’s financial position (Conceptual Framework, paras OB12–OB16). The presentation of financial reports is prescribed to ensure that they are comparable with the entity’s previous financial statements and with the financial statements of other entities (IAS 1, para. 1). The statement of financial position (orbalance sheet) provides information about the financial position of the entity. The statement of profit or loss and other comprehensive income (P&L and OCI) (also referred to as the ‘statement of financial performance’ or just ‘profit or loss statement’) reports on performance onan accrual basis. The statement of cash flows reports on performance on a cash basis. Changes in the net assets, or equity, are reported in the statement of changes in equity.

The importance of financial reporting Financial reporting is important because of the often significant level of resources under the responsibility of managers and the financial impact of the decisions made by users based on this information. This importance is reflected in company regulators and stock exchanges around the world requiring financial statements to be prepared by entities as part of their reportingobligations. The types of decisions that financial statementsmight beused for are highlighted in Figure 1.1.

Figure 1.1: Financial statement user decisions

Shareholders

Competitors

Should I invest money in the company?

How has the company performed in comparison to its competitors?

? Suppliers

Banks

Should I sell goods to the company?

Should I lend money to the company?

Source: CPA Australia 2016.

STUDY GUIDE |

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As previously mentioned, the primary users of financial information are existing and potential investors, lenders and other creditors (Conceptual Framework, para. OB2). Other users of financial information include regulators and members of the public, such as community groups and potential employees. Many of these users are unable to require specific information to be provided directly to them and must therefore rely on general purpose financial reports. Entitiesarerequired to prepare general purpose financial reports specifically to assist their primary users in their decision-making. The information needs of these users may differ. Forexample, current investors are interested in deciding whether to hold or sell their investment, whereaspotential investors are interested in deciding whether or not to buy an investment. Thesedecisions may give rise to varying or even conflicting information needs. The IASB’s approach to resolving conflicting user information needs is to provide the information that will meet ‘the needs of the maximum number of primary users’ (Conceptual Framework, para.OB8). However, it is noted that focusing on common information needs does not prevent anentity from providing additional information that may be useful to another sub-group of primary users (Conceptual Framework, para. OB8). Conflicting information needs are shown in Figure 1.2. The shaded area represents the common information needs of primary user groups. Conflict arises where the information needs do not overlap, as indicated by the unshaded areas, and where the information needs of only twouser groups are shared (striped areas). The unshaded and the striped areas depict differinginformation needs, where choices made by standard setters and preparers may result in the needs of some primary users being met at the expense of the needs of other primary users.

Figure 1.2: Maximising the number of primary users whose information needsaremet

Investors

Lenders

Other creditors

Source: Adapted from IFRS Foundation 2017, Conceptual Framework for Financial Reporting, parasOB5–OB8, in 2017 IFRS Standards, IFRS Foundation, London, pp. A27–8. © CPA Australia 2015.

Consider, for example, lenders as users of financial statements. Lenders are interested in makingan assessment of an entity’s capacity to meet its principal and interest obligations and the level of risk associated with a loan. As investors invest equity, they are also interested in the assessment of risk and the ability of the entity to service its debt, so that the entity can continue its operations and provide a return to investors. These varying demands may give rise to different preferences for the measurement of assets or the timing of the recognition of revenue. For example, creditors may prefer a measure of the net realisable value of certain assets to assess whether the security is sufficient in the event that the entity defaults on repayment. However, investors may prefer measurement based on value in use, which provides a better indication of the expected benefits to be derived from the c...