ACCA F7 (Question 4 and 5)

Conceptual framework for financial reporting identifies faithful representation

as a fundamental characteristic of useful financial information

Distinguish between fundamental and enhancing qualitative characteristics and
explain why faithful representation is important

The Conceptual Framework for Financial Reporting implies that the two
fundamental qualitative characteristics (relevance and faithful representation)
are vital as, without them, financial statements would not be useful, in fact they
may be misleading. As the name suggests, the four enhancing qualitative
characteristics (comparability, verifiability, timeliness and understandability)
improve the usefulness of the financial information. Thus financial information
which is not relevant or does not give a faithful representation is not useful (and
worse, it may possibly be misleading); however, financial information which
does not possess the enhancing characteristics can still be useful, but not as
useful as if it did possess them.
In order for financial statements to be useful to users (such as investors or loan
providers), they must present financial information faithfully, i.e. financial
information must faithfully represent the economic phenomena which it
purports to represent (e.g. in some cases it may be necessary to treat a sale and
repurchase agreement as an in-substance (secured) loan rather than as a sale
and subsequent repurchase). Faithfully represented information should be
complete, neutral and free from error. Substance is not identified as a separate
characteristic because the IASB says it is implied in faithful representation such
that faithful representation is only possible if transactions and economic
phenomena are accounted for according to their substance and economic reality.

The objective of IFRAS 5 Non-current assets held for sale and discontinued
operations specifies, amongst other things, accounting for and presentation and
disclosure of discontinued operations.

Defined a discontinued operation and explain why the disclosure is important to
users of financial statements

A discontinued operation is a component (see below) of an entity that has either
already been disposed of or is classified as held for sale that represents a
separate major line of business or geographical area of business operations (or is
part of a co-ordinated plan to dispose of such). It also applies to a subsidiary that
is acquired specifically with a view to resale.
A component of an entity has operations and cash flows that are clearly
distinguished for reporting purposes from those of the rest of an entity. It would
normally be a cash generating unit (or a group of cash generating units) or a
subsidiary.
This information is important to users of financial statements when they are
forming an assessment of the likely future performance of an entity. For
example, if a group made a large profit from one of its subsidiaries that it has
recently sold (or will soon sell), this will have a material effect on any forecast of
the groups future profit. This is because the profits from the subsidiary disposed
of will no longer contribute to future group profit (though the re-investment of
any sale proceeds from the disposal could). Also, the converse would be true
where the disposal or closure of a loss-making subsidiary could improve future
profitability.

Define investment property under IAS 40 and explain why its accounting
treatment is different from that of owner-occupied property

An investment property is land or buildings (or a part thereof) held by the owner
to generate rental income or for capital appreciation (or both) rather than for
production or administrative use. It would also include property held under a
finance lease and may include property under an operating lease, if used for the
same purpose as other investment properties. Generally, non-investment
properties generate cash flows in combination with other assets, whereas a
property that meets the definition of an investment property means that it will
generate cash flows that are largely independent of the other assets held by an
entity and, in that sense, such properties do not form part of the entitys normal
operations.

Explain how the treatment of an investment property carried under the fair
value model differs from an owner-occupied property carried under the
revaluation model.

Superficially, the revaluation model and fair value sound very similar; both
require properties to be valued at their fair value which is usually a market-
based assessment (often by an independent valuer). However, any gain (or loss)
over a previous valuation is taken to profit or loss if it relates to an investment
property, whereas for an owner-occupied property, any gain is taken to a
revaluation reserve (via other comprehensive income and the statement of
changes in equity). A loss on the revaluation of an owner-occupied property is
charged to profit or loss unless it has a previous surplus in the revaluation
reserve which can be used to offset the loss until it is exhausted. A further
difference is that owner-occupied property continues to be depreciated after
revaluation, whereas investment properties are not depreciated.

The objective of IAS 36 Impairment of assets is to prescribe the procedures that
an entity applies to ensure that its assets are not impaired.

Explain what is meant by an impairment review. Your answer should include
reference to assets that may form a cash generating unit.

An impairment review is the procedure required by IAS 36 Impairment of assets
to determine if and by how much an asset may have been impaired. An asset is
impaired if its carrying amount is greater than its recoverable amount. In turn
the recoverable amount of an asset is defined as the higher of its fair value less
costs to sell or its value in use, calculated as the present values of the future net
cash flows the asset will generate.
The problem in applying this definition is that assets rarely generate cash flows
in isolation; most assets generate cash flows in combination with other assets.
IAS 36 introduces the concept of a cash generating unit (CGU) which is the
smallest identifiable group of assets that generate cash inflows that are (largely)
independent of other assets. Where an asset forms part of a CGU any impairment
review must be made on the group of assets as a whole. If impairment losses are
then identified, they must be allocated and/or apportioned to the assets of the
CGU as prescribed by IAS 36.

The methods by which accounting standards are developed differ considerably
throughout the world. It is often argued that there are two main systems of
regulation that determine the nature of accounting standards, a rules-based
system and a principles-based system.

Briefly explain the difference between the two systems and state which system
you believe is most descriptive of international financial reporting standards.

A rules-based accounting system is likely to be very descriptive and is generally
considered to be a system which relies on a series of detailed rules or accounting
requirements that prescribe how financial statements should be prepared. Such
a system is considered less flexible, but often more comparable and consistent,
than a principles-based system. Some would argue that rules-based systems can
lead to looking for loopholes. By contrast, a principles-based system relies on
generally accepted accounting principles that are conceptually based and are
normally underpinned by a set of key objectives. They are more flexible than a
rules-based system, but they do require judgement and interpretation which
could lead to inconsistencies between reporting entities and can sometimes lead
to the manipulation of financial statements.
Because IFRSs are based on The Conceptual Framework for Financial Reporting,
they are often regarded as being a principles-based system. Of course IFRSs do
contain many rules and requirements (often lengthy and complex), but their
critical feature is that IFRS rules are based on underlying concepts. In reality
most accounting systems have an element of both rules and principles and their
designation as rules-based or principles-based depends on the relative
importance and robustness of the principles compared to the volume and
manner in which the rules are derived.