Accounting Standards Lecture

Accounting Standards

2.1 Introduction

The divorce of ownership and control in businesses leads to a need for some form of assurance of the information presented by the business to the owners. The owners or shareholders of a business are generally reliant on the financial statements and annual report to satisfy themselves of the value or return from their investment in the business. In addition, there is a need for investors, be they shareholders, banks and other creditors or suppliers to be able to assess the viability of one business as compared to another and this is only possible if there is some consistency across the financial statements and reporting requirements.

Furthermore, accounting standards should remove subjectivity that could lead to inaccurate information. Examples of this go back a long time in history from 1967 and the GEC takeover of AEI which saw a forecast profit on £10 million at acquisition change to a loss of £4.5 million post acquisition. This huge variation was mainly due to differences in judgement. This acquisition, along with other cases such as the Pergamon Press misstatements in 1968 where it was revealed that the auditors had radically disagreed with the timing of profit recognition on sales, led to the public and investors calling for action and as such the introduction of Statements of Standard Accounting Practice. Prior to this, there had been no professional mandatory standards.

However, over the last 50 years businesses have grown and expanded in geography and complexity and as such the need for ongoing changes to standards of financial reporting and auditing continue. This is evidenced by continuing failures of businesses due to concealment of issues within the legislative and mandatory reporting requirements. Enron were able to conceal the fact that they had off balance sheet debts and overstated profits by more than $500 million.

In the following section, the history of the regulatory framework will be summarised from a UK perspective. This history will outline the two main UK influences on financial reporting which are the Accounting Standards Board (ASB) and the International Accounting Standards Board (IASB).

The purpose of accounting standards will then be considered before examining some of the more common standards that are both applicable to many companies and subject to some degree of subjectivity. These have been identified as; -

• IAS 2 Inventories
• IAS 16 Property, Plant and Equipment
• IAS 17 Leases
• IAS 36 Impairment of Assets
• IAS 38 Intangible Assets

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2.2 The Regulatory Framework - an overview

Most of the developed countries around the world have enacted legislation which is in place to govern financial reporting by limited companies. In the UK this enacted legislation is found in the Companies Act 2006 and it covers a variety of matters including the records that must be kept, requirement to prepare annual accounts that provide a ‘true and fair’ view and the circulation and disclosure of accounts. The Companies Act 2006 also states that accounts must be prepared in accordance with either national or international standards.

Below these broad rules set out by enacted legislation there are the accounting standards. The table below sets out the key developments in the late 20^th century onwards as these are either still applicable or remain the most common influences on standards today.

Governing Body	Applicable Country	Comments
Accounting Standards Steering Committee (ASCC).  - renamed Accounting Standards Committee (ASC) in 1975	UK	Established in 1970 with the intention of narrowing the areas of difference and variety in accounting practice.  Published Statements of Standard Accounting Practice (SSAP) which covered areas identified as having a greater need for disclosure because reported values where potentially dependent upon estimates of the future.  Members of the ICAEW were under a professional duty to apply standards, and would be subject to disciplinary proceedings if they failed to comply. Issues over acceptance and in some instances compliance to the standards led to the undermining of the ASC. The government also began to include more legislation in the companies act that was not always congruent with the SSAPs. The Dearing review determined that the ASC’s was not independent of the professional accountancy bodies, that it was not adequately resourced, and it could not effectively enforce its standards.
Financial Reporting Council	UK	Established as part of the Dearing review. The UK's and the Republic of Ireland's independent regulator responsible for promoting high quality corporate governance and reporting to foster investment. The FRC has six bodies within the structure including the Accounting Standards Board (ASB).
Accounting Standards Board (ASB)	UK	Took over from the ASC in 1990. Adopted the SSAPs initially but gradually began to replace SSAPs with Financial Reporting Standards (FRSs).
International Accounting Standards Committee (IASC)	International	Established in 1973 and responsible for developing the International Accounting Standards (IAS) and promoting the use and application of these.
International Accounting Standards Board (IASB)	International	Formed in 2001 under the International Financial Reporting Standards Foundation and replaced the International Accounting Standards Committee (IASC). Initially adopted the IASs and then as standards developed further these are known as International Financial Reporting Standards (IFRSs). Growing international capital markets and differences between national and international standards led to criticism of national standards. The effects of the Enron and other scandals in the USA were felt in the UK and this stimulated pressure for companies listed on UK markets to adopt International Financial Reporting Standards (IFRS).  Changes in UK company law pursued and the expectation that companies who adopt the IFRSs no longer need to apply FRSs and all listed companies and certain regulated financial companies were required to adopt IFRS for accounting periods beginning on or after 1 January 2005.

It is also worth briefly commenting on generally accepted accounting practice (GAAP). The concept of GAAP is to collect together all the regulations that apply to a jurisdiction (or country) along with any other general accounting conventions which are applied and then encompass these under the banner of GAAP. This can be UK GAAP or US GAAP or any other country for that matter.

2.3 The International Accounting Standards Board

As mentioned above, the IASB operate within the IFRS Foundation and are the independent standard setting body of the organisation. The IASB publish IFRSs but they also adopted the standards that were in place when they replaced the IASC. The adopted standards are IASs. There are currently 28 IASs and 13 IFRSs in force. A full list of the standards that are currently in place can be found on the IFRS website[1].

2.4 Purpose of Accounting Standards

The above information has made some reference to the purpose of accounting standards, but it is worthwhile to reiterate and expand on this a little further.

The main purpose is to try to reduce or eliminate variations in accounting practice and reporting. This should allow users of the statements to have some confidence that the financial statements adequately reflect the performance of the business and it should allow those users to compare statements with degree of confidence that they are comparing ‘apples with apples’.

The IASB have developed a conceptual framework which considers the objective of financial reporting and the qualitative characteristics of useful financial information. The conceptual framework serves as a guide for the preparation and presentation of financial statements and as a reference to anchor new standards against. The framework sets out six ‘qualitative characteristics’ of useful financial information; relevance, faithful representation which are described as fundamental and then comparability, verifiability, timeliness and understandability which are described as enhancing.

The objective of the IASB and the IFRSs is to maximise the qualities as far as possible through the conceptual framework and the published standards.

It has taken a long time for financial reporting to begin to gain some form of alignment internationally. Before the IASB, there had been little agreement on the accounting treatment with some policies in different countries at complete odds with each other. The wider adoption by listed companies of the IFRS is moving everyone to a global recognised approach and therefore simplifying things from the perspective of an investor.

3 Key Reporting Standards

Whilst there are 41 International standards in force, many of these are relatively straightforward in respect of their application in financial reporting. There are however a few standards that are deemed to be more difficult to understand and require a greater amount of critical analysis to ensure that they are applied correctly, and these will each be considered further.

3.1 IAS 2 Inventories

IAS 2 defines inventories as ‘assets:

1. Held for sale in the ordinary course of business;
2. In the process of production for such sale; or
3. In the form of materials or supplies to be consumed in the production process or in the rendering of services’.

The standard provides guidance on the determination of cost and net realisable value and prescribes the valuation rule.

IAS 2 states that the cost of inventories includes costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. The table below sets out the key elements that can generally be included as cost for guidance. This list is not definitive, and each item will need to be considered as to the underlying substance of the transaction.

Costs of Purchase	Purchase price less trade discounts Import duties Other taxes (if not recoverable0 Transport costs Handling costs
Costs of conversion	Direct costs of production Direct labour Allocation of fixed and variable overheads incurred in the conversion of materials to finished goods EXCLUDES: abnormal wastage, storage costs, admin overheads and selling costs

A business will accumulate inventories over time and as a result the cost of each item of stock will differ depending upon the purchase price at the time or the cost of conversion. Prices may have risen, labour costs may have gone up, trade discounts may have reduced. There are many things that can change during the time that inventories accumulate in a business.

As such if there was no specified approach it would be possible for a business to manipulate the profit or loss for the year by choosing which items of stock at which value to include in cost of sales for the period.

As such the standard specifies two allowable methods for the determination of inventory use; first-in, first-out (FIFO) or weighted average cost (AVCO). Examples of both methods are shown below.

Company XYZ hold an inventory of 12,000 widgets as at 31 December 2015 bought for £100 per widget. Additional purchases and sales of widgets throughout the year were as follows:
Purchases			Sales
Date	Number	Purchase Price	Date	Number
04-Apr-17	2000	105	31-Mar-17	7,000
27-Jun-17	5000	110	02-Jun-17	4,000
06-Oct-17	6000	117	30-Sep-17	6,000
14-Dec-17	4000	106	28-Nov-17	6,000

The costs associated with the sales using the FIFO method and the AVCO method as well as the closing inventory value are shown below.

FIFO (using the above data)	Number			Cost
Sold 31 March	7000	7,000 @ £100	700,000	700,000
Sold 2 June	4000	4,000 @ £100	400,000	400,000
Sold 30 Sept	6000	1,000@ £100	100,000
		2,000 @ £105	210,000
		3,000 @ £110	330,000	640,000
Sold 28 Nov	6000	2,000 @ £110	220,000
		4,000 @ £117	468,000	688,000
Inventory at 31 December 2017	6,000	2,000 @ £117	234,000
		4,000 @ £106	424,000	658,000

AVCO (using the above data for the first half of the year)	Number	Price	Total Cost
Opening Inventory	12,000	100.00	1,200,000
Sold 31 March	7,000	100.00	700,000
	5,000	100.00	500,000
Bought 4 April	2,000	105.00	210,000
	7,000	101.43	710,000
Sold 2 June	4,000	101.43	405,714
	3,000	101.43	304,286
Bought 27 June	5,000	110.00	550,000
Inventory at 30 June	8,000	106.79	854,286

As is common across all aspects of accounting for the balance sheet, the standard specifies that stock must be carried at the lower of cost and net realisable value.  This means that should there be any expected loss from the sale of an item of stock then the loss is recognised immediately rather than waiting for the item to be sold. This is in line with the idea of the balance sheet being a reasonable representation of the asset value of the business.

It should also be noted that the standard excludes construction contracts which are dealt with separately under IAS 11.

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3.2 IAS 16 Property, Plant and Equipment

This standard sets out what criteria needs to be met to recognise an item of property or plant and equipment as an asset on the balance sheet. It sets out how to measure the value for the financial statements and how to calculate and account for depreciation.

The standard defines property, plant and equipment as ‘tangible items that;

1. Are held for use in the production or supply of goods or services, for rental to others, or for administration purposes; and
2. are expected to be used during more than one period’.

The term carrying amount which is used throughout the standard to refer to the value that is assigned to the asset in the balance sheet, or in other words, the value it is carried in the balance sheet.

For an asset to be accrued at a value in the balance sheet, it must be of use in the business and be a contributing asset to the future of the business and it must be possible to measure the value. Confirming that an asset has a future economic benefit for the business can be an area of contention and requires judgement to be exercised.

In should also be noted that any routine maintenance incurred on an asset after it has been recognised in the financial statement is generally not deemed to be capital, but some major works are treated as capital expenditure. The example of a locomotive can again be used to understand this. At various key stages in their life, a locomotive will require a ‘heavy overhaul’ which requires replacement of significant parts of the locomotive. In this case the part that is replaced should be written down to zero and the replacement part should be added to the capital value of the asset. This can make accounting treatment difficult on assets such as aircraft, ships and locomotive that are made up of several significant parts that when replaced can be deemed as additional capital expenditure.

It should be noted that when an asset is written off or part of the asset ‘derecognised’, the profit or loss on that asset or part thereof should be recognised immediately in the profit and loss account for the period.

When an asset is first recognised in the financial statements it should be at cost where cost is

• The purchase price plus import duties and any non-refundable purchase taxes less trade discounts or rebate plus any costs incurred in getting the item to the location or making it operable which includes labour, delivery and handling costs, installation and professional fees.

Note it is also possible to capitalise the estimated costs of dismantling and removing the asset if the obligation to meet the costs is incurred at the time that the item is acquired. The above definition of what is included in cost applies to self-constructed assets also.

After recognition at cost the asset is carried at cost less accumulated depreciation and less any impairment losses (see IAS 36) but can be revalued and carried at a revalued amount. This value will be the fair value of the asset which means the value that could be received for the asset at the point of revaluation. IFRS13 deals with Fair Value Measurement.

Any increase in the carrying amount because of revaluation must be credited to a revaluation reserve and shown separately in the financial statements. This ensures that these gains which are not cash gains cannot be used for dividend payments. If an asset value is decreased, then it must be shown as an expense and a debit revaluation balance. Any reversal of the valuation at a future date should be offset against the initial revaluation reserve and income or expense.

Once the asset is disposed of the revaluation reserve can be transferred to retained earnings as any previous loss or gain that was unrealised (from a cash perspective) will have been realised on sale.

IAS 16 also defines and describes the depreciation process. Depreciation charges are charged as an expense to the profit and loss but are simply there to allocate expenses to accounting periods. A business should consider how long the useful life of an asset is in providing economic benefit to the business and whether at the end of that time there will be any residual value and then allocate a cost each accounting period accordingly.

There are several methods that can be adopted for depreciation; straight line, reducing balance or units of production.

XYZ manufacturing purchase a machine at a cost of £120,000. The machine is expected to have a useful life of 4 years and a residual value of £20,000.
The Number of units that the machine is expected to produce over its useful life are as follows;
Year	Number of Units
2016	30,000
2017	40,000
2018	45,000
2019	30,000

Straight-Line Method
The amount that needs to be depreciated is £120,000 less the residual value of £20,000. The useful life is 4 years, so the annual depreciation charge is £100,000 divided by 4 years of life; £25,000 per annum.
Reducing Balance Method		0.35
Year	Carrying Amount	Depreciation @ 35%	Carry Forward Amount
2016	120,000	42,000	78,000
2017	78,000	27,300	50,700
2018	50,700	17,745	32,955
2019	32,955	11,534	21,421
It can be seen that the difficulty with a reducing balance method is that it is unlikely to leave the exact residual value at the end of the full life depreciation unless the depreciation value is calculated mathematically, and this would give an odd decimal value in some cases for the depreciation percentage. In reality, it is easier to use a value that gains an approximation to the residual value.
Units of Production Method		0.35
Year	Units Produced	Depreciation @ 70p per unit
2016	30,000	21,000
2017	40,000	28,000
2018	45,000	31,500
2019	30,000	21,000
	145,000	101,500
The unit rate for depreciation is calculated by taking the cost less residual value of £100,000 and dividing by the total expected units to be produced.

3.3 IAS 17 Leases

IAS 17 defines a lease as ‘an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time’.

The standard describes two types of leases. A finance lease which conveys the risks and rewards that someone might normally associate with ownership of the lease and an operating lease which is any other type of lease that is not a finance lease.

The standard provides a list of examples that would normally lead to a finance lease classification, but these are not always conclusive, so it is important to look at the features in the agreement to understand if the lease is transferring the risks and rewards of ownership.

Because a finance lease confers risks and rewards it can be treated as asset ownership and accounted for accordingly. The asset should be included in assets and the lease liability in liabilities.  The amount at which the asset should be included is the lower of the fair value of the asset or the present value of the minimum lease payments. The asset will then be treated in accordance with IAS 16.

The lease payments need to be split between the amount that reduces the liability and the interest or finance charge. This finance charge should be charged to accounting periods to spread the expense in a proportionate manner over the period of the liability and there are a number of methods that can be used to do this; the actuarial method, the sum of digits method and the level spread method. The use of these methods is shown in the examples below.

XYZ manufacturing purchase a machine on a finance lease with a fair value of £20,000. The company is required to make four payments of £6,654 which fall on 31 March each year and the interest rate implicit in the lease is 12.5%.

Level Spread Method
The total finance charge is the difference n=between the fair value of £20,000 and the lease payments of £26,616. This finance charge of £6,616 is spread evenly over the 4 years of the lease giving an annual finance charge of £1,654
Sum of Digits Method
Year	Digit	Finance Charge	Annual Charge
2016	4	4/10 x £6,616	2,646
2017	3	3/10 x £6,616	1,985
2018	2	2/10 x £6,616	1,323
2019	1	1/10 x £6,616	662
	10		6,616

The sum of digits method is used to provide a reasonable approximation to the actuarial method is the implicit interest rate is not known.

Compare the annual finance charge calculated above in the sum of digits with the finance charge calculated below using the actuarial method.

Actuarial Method		0.35
Year	Liability b/f	Finance Charge @12.5%	Lease Payment	Liability c/f
2016	20,000	2,500	6,654	15,846
2017	15,846	1,981	6,654	11,173
2018	11,173	1,397	6,654	5,915
2019	5,915	739	6,654	1

The actuarial method is the most accurate measure and ensures that the interest charged to the profit and loss is the actual interest on the outstanding liability but cannot be used if the rate is not known.

It should also be noted that the IASB are currently developing a new lease standard to supersede IAS17 and it is expected that this will make significant changes to the accounting treatment of leases. It is expected that this new standard will require the treatment of both finance and operating leases to be the same.

3.4 IAS 36 Impairment of Assets

IAS 36 defines an impairment loss as ‘the amount by which the carrying amount of an asset or cash-generating unit exceeds its recoverable amount’. The standard only expects a business to determine the recoverable amount of an asset if there is an indication that the asset may have been impaired with the exception of intangible assets and goodwill (see IAS 38). The standard provides examples of when this indication may or should be apparent.

The following indications are noted in IAS36 but are not exhaustive. However, if any of these exist then the asset must be tested for impairment.

• Visible indication of decline
• Market changes (which may have made the technology redundant for example)
• Interest rate increases - this can be difficult to understand but if the asset was purchased using a discount rate against the investment decision then that decision may be altered now that the rate has changed.
• If the net assets of the business exceed the total market value of the share capital - again this is understandable if one considers that the share price is an indication of the value of a business
• Significant changes in the use of the asset
• Evidence that the performance of the asset is not as expected

The recoverable amount of an asset is the higher of its fair value less any costs of disposal or its value in use. In reality if either of these two values is higher than the recoverable amount of the asset then there is no impairment. Fair value was defined earlier under IAS 16 and value in use is calculated by discounting future cash flows that the asset is expected to generate. It is clear that this will be an area where judgement is used and auditing the position may be very difficult as estimating the value in use will require estimates of future cash flows. The standard states that they must be based on reasonable and supported assumptions with greater weight given to external evidence of validity rather than internal evidence.

When an impairment is identified, IAS 36 requires that the asset’s carrying amount is reduced and the impairment loss is recognised as an expense in the period unless the asset is carrying a revaluation amount in which case the loss is accounted for in the same manner as a revaluation decrease as described in IAS 16. As such it is debited to the revaluation reserve and shown as negative ‘other comprehensive income’ to the extent that it matches the revalued amount. An impairment over and above the revalued amount should be shown as an expense.

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3.5 IAS 38 Intangible Assets

IAS 38 defines an intangible asset as ‘an identifiable, non-monetary asset without physical substance’. The standard is clear that the item must be an asset first and foremost. That means that the item must be able to demonstrate future economic benefit and the business must have control of that future economic benefit, i.e., own the asset.

The key difference with an intangible asset is that unlike property, plant and equipment, it does not have any physical substance. Examples of intangible assets are goodwill, patents, trademarks and copyrights. None of these assets have any physical substance but they all can still potentially have value.

It is possible to have acquired intangible assets as well as internally generated intangible assets. The standard specifically states however, that internally generated goodwill cannot be classified as an intangible asset.

An acquired intangible asset is relatively straightforward to value as the cost can be recognised in the same way as the cost of a tangible asset is recognised; purchase price including import duties after deducting trade discounts etc. but an internally generated intangible asset is a little harder and so the standard uses guidelines for this.

The standard splits the asset into two phases; the research phase and the development phase.

Research cover activities aimed at gaining new knowledge and ways to apply that knowledge but because at this stage of investment a business cannot demonstrate that the research has a future economic benefit the costs cannot be treated as an asset and must be accounted for as an expense as incurred.

However, in the development phase, the standard accepts that it may be possible to determine future economic benefits. The standard is specific in that if a set of defined criteria can be demonstrated then the project must be accounted for as an intangible but any project that does not meet all the criteria must be accounted for directly as an expense. It is also not possible to change the treatment of past expenditure that has already been written off as an expense.

After the determination of an intangible asset the standard very much allows the treatment of the asset to be similar to the treatment of any asset as per IAS 16. The asset can be carried at cost or revalued but note that the asset can only be revalued if there is an active market for the asset. Most intangibles are unique and so this is unlikely to be the case. Revaluation are accounted for in a revaluation reserve as for tangible assets.

4 Conclusion

It is clear that the need for accounting standards has increased over the last century in line with the increased influence of business on both the economy and an ever-increasing range of stakeholders. If there are issues with global companies, the impact is felt far and wide and as such improved consistency in reporting and better governance is critical.

Accounting standards have developed slowly through the last 60 years from attempts to apply some form of cohesive thinking to a more regulated approach being adopted. The latest standards used by large companies are international in nature and carry more authority through regulation and legislation than ever before.

The range of standards is broad but the key aspect when interpreting the standards is to bear in mind the purpose of financial reporting and refer to the conceptual framework and whether the accounting treatment enhances the qualitative aspects of the reporting or not.

A basic overview of some of the more commonly referred to standards is provided and it is clear that there is little subjectivity in the application of these standards although there are different methods. It is worth noting that these methods are disclosed in financial reporting and so users of the statements are still able to undertake a comparison as they understand the differences in the standard adopted between comparison companies and can adjust their thinking accordingly.

Recommended Texts

Melville, A., 2014. International Financial Reporting: A Practical Guide. 4th ed. Harlow: Pearson Education Limited.

[1] http://www.ifrs.org/issued-standards/list-of-standards/