IASB's restructured Conceptual Framework raises thorny issues

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This article was first published in the April 2017 international edition of Accounting and Business magazine.

Some of the proposals from the International Accounting Standards Board (IASB) for updating its Conceptual Framework for Financial Reporting 2010 have led to detailed discussion as revisions approach the completion stage.

The IASB has proposed changes to the definitions of assets and liabilities in chapter 4 of the framework. To casual observers, it might seem like some of these are the equivalent of repainting white walls as cream; to other users it might feel like a whole new palette. 

The changes under discussion are explained in the box on page 50. The IASB has proposed a shift in the fundamental definition of assets and liabilities. While the concept of control remains, the key change – alongside the concept of a present obligation for liabilities – is the replacement of the term ‘expected’. For assets, expected economic benefit is replaced with the potential to produce economic benefits. For liabilities, the expected outflow of economic benefits is replaced with the potential to require the entity to transfer economic resources.

The reason for this change is that some people interpret ‘expected’ to mean that an item can be an asset or liability only if some minimum threshold were exceeded. As the IASB has applied no such interpretation in setting recent International Financial Reporting Standards, it has altered the definition in an attempt to improve clarity.

The IASB has acknowledged that some standards do include probability criteria for recognising assets and liabilities. For example, IAS 37, Provisions, Contingent Liabilities and Contingent Assets, states that a provision can be recorded only if there is a probable outflow of economic benefits, while IAS 38, Intangible Assets, highlights that for development costs to be recognised there must be probable economic benefits arising from the development. 

The proposed change to the definition of assets and liabilities will leave these unaffected. The IASB has explained that these standards don’t rely on an argument that items fail to meet the definition of an asset or liability. Instead, the standards include probable inflows or outflows as a criterion for recognition. The IASB believes that this uncertainty is best dealt with in the recognition or measurement of items, rather than in the definition of assets or liabilities.

Practical additions

No separate section on measurement bases currently exists in the Conceptual Framework, as it was thought to be unnecessary. However, when you’re undertaking a project of the magnitude of redrafting the framework, you may as well put in some additions that are helpful and practical, even if you’ve previously managed without them. 

In the existing framework, there are a few paragraphs outlining possible measurement bases, but they are limited in detail. The proposed changes, in chapter 6, will add an entire section on the measurement of elements in the financial statements. Of all the proposed changes in the framework, this is the one that is still under detailed discussion, so here are the main decisions to date.

The first of the measurement bases discussed is historical cost. The accounting treatment of this is unchanged, but the framework now outlines that the carrying amount of non-financial items held at historical cost is adjusted over time to depict the usage (in the form of depreciation or amortisation) or items suggesting the historical cost is no longer recoverable (impairment). Financial items held at historical cost will reflect subsequent changes such as interest and payments, following the principle often referred to as amortised cost.

The framework also outlines three measurements of current value: fair value, value in use and current cost. Fair value continues to be defined as the price in an orderly transaction between market participants. Value in use is defined as an entity-specific value, and remains as the present value of the cashflows an entity expects to derive from the continuing use of an asset and its ultimate disposal. Current cost is different from fair value and value in use, as it is an entry value. It looks at the value at which the entity would acquire the asset (or incur the liability) at current market prices; by contrast, fair value and value in use are exit values, focusing on the values that will be gained from the item.

Examples for guidance

In addition to outlining these measurement bases, the framework discusses them in the light of the qualitative characteristics of financial information. It stops short of recommending the bases that items should be held under, but gives some guidance in the form of examples to show where certain bases may be more relevant.

Relevance is a key issue here. As discussed in the revised framework, historical cost may not provide relevant information about assets held for a long period, and is certainly unlikely to provide relevant information about derivatives. In both cases, it is likely that some variation of current value will be used to provide more predictive information to users.

Conversely, the framework suggests that fair value may not be relevant if items are held solely for use or to collect contractual cashflows. Alongside this, it specifically mentions items used in combination to generate cashflows by producing goods or services to customers. As these items are unlikely to be able to be sold separately without penalising the activities, a cost-based measure will probably provide more relevant information, as the cost is compared to the margin made on sales.

Constructive criticism

Some key issues in chapter 7 on presentation and disclosure have changed since previous drafts. Originally this chapter included two rebuttable presumptions regarding other comprehensive income (OCI). While the conclusion reached remains largely the same, many commentators felt that rebuttable presumptions shouldn’t exist in the framework. The IASB agreed, and has replaced them with stated principles regarding the use of OCI.

The first of these principles is that income and expenses should be included in the statement of profit or loss unless relevance or faithful representation would be enhanced by including a change in the current value of an asset or a liability in OCI.

The second relates to the recycling of items in OCI into profit or loss. Under IAS 1, Presentation of Financial Statements, items should be shown as reclassified into profit or loss, or not reclassified.

The recycling of OCI is a contentious issue. Some argue that all OCI items should be recycled; some that OCI items should never be recycled; and some that only certain items should be recycled. Sometimes the best way forward isn’t necessarily to seek the wisdom of crowds.

Middle ground

The IASB has found a middle ground. The framework will now state that income and expenses included in OCI should be recycled when doing so would enhance the information’s relevance or faithful representation. Items in OCI may not be recycled if there is no clear basis for identifying the period in which recycling should occur.

These are the key findings to date. In most cases, they will be seen as minor changes to terminology, or simply outlining what already exists. However, debate on the concepts of measurement and OCI is sure to rumble on. 

Adam Deller is a financial reporting specialist and lecture