Professional Documents
Culture Documents
Financial Reporting Book
Financial Reporting Book
Financial Reporting Book
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This is an extract from a subject guide for an undergraduate course offered as part of the
University of London International Programmes in Economics, Management, Finance and
the Social Sciences. Materials for these programmes are developed by academics at the
London School of Economics and Political Science (LSE).
For more information, see: www.londoninternational.ac.uk
The 2016 edition of this guide was prepared for the University of London International
Programmes by:
Professor J. Haslam, Heriot-Watt University
and
Dr D.Chow, Durham University
It draws on previous editions of the guide prepared by J. Horton and S. Miles
Professor J. Horton, BSc, M Phil, PhD, Department of Accounting, University of Exeter Business
School.
It was revised and updated in 2007 by:
S. Miles, PhD. Department of Accounting, The Business School, Oxford Brookes University.
This is one of a series of subject guides published by the University. We regret that due
to pressure of work the authors are unable to enter into any correspondence relating to,
or arising from, the guide. If you have any comments on this subject guide, favourable or
unfavourable, please use the form at the back of this guide.
The University of London asserts copyright over all material in this subject guide except where
otherwise indicated. All rights reserved. No part of this work may be reproduced in any form,
or by any means, without permission in writing from the publisher.
We make every effort to respect copyright. If you think we have inadvertently used your
copyright material, please let us know.
Contents
Contents
Introduction............................................................................................................. 1
Aims and objectives of this course.................................................................................. 1
Learning outcomes......................................................................................................... 1
Syllabus.......................................................................................................................... 2
How to use this guide..................................................................................................... 2
Essential reading............................................................................................................ 3
Further reading............................................................................................................... 4
Online study resources.................................................................................................... 6
Preparation for the examination...................................................................................... 7
Overview of the guide.................................................................................................... 8
Index of abbreviations used in this guide......................................................................... 9
Chapter 1: Rationale for financial reporting and its regulation........................... 11
Aims of the chapter...................................................................................................... 11
Learning outcomes....................................................................................................... 11
Essential reading.......................................................................................................... 11
Further reading............................................................................................................. 11
Financial accounting theory.......................................................................................... 12
Financial accounting and its role................................................................................... 13
Financial accounting regulation.................................................................................... 15
Accounting standards: what form should they take?...................................................... 17
Descriptions of accounting and its regulation................................................................ 19
UK accounting regulation and the influence of international accounting standards........ 20
Institutional setting for accounting regulation: the UK................................................... 20
Statutory regulation: IASs/IFRSs gained force of law...................................................... 22
Mandatory regulation: standard-setting and the case of the UK..................................... 23
Stock Exchange............................................................................................................ 25
Reminder of learning outcomes.................................................................................... 26
Sample examination questions...................................................................................... 27
Chapter 2: Conceptual framework........................................................................ 29
Aims of the chapter...................................................................................................... 29
Learning outcomes....................................................................................................... 29
Essential reading.......................................................................................................... 29
Further reading............................................................................................................. 29
Definition of a conceptual framework............................................................................ 30
Rationale for a conceptual framework........................................................................... 31
Advantages claimed for a conceptual framework........................................................... 31
The US, IASC and UK initiatives compared..................................................................... 32
Objectives of financial reporting.................................................................................... 33
Qualitative characteristics of accounting information..................................................... 35
Elements of financial statements................................................................................... 38
Recognition and measurement in financial statements SFAC 5, SOP............................... 41
Presentation of financial information............................................................................. 44
Review of the conceptual framework ........................................................................... 45
Conclusions.................................................................................................................. 46
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AC3091 Financial reporting
ii
Contents
Introduction............................................................................................................... 188
Goodwill: the debate.................................................................................................. 188
Intangible assets (other than goodwill)....................................................................... 194
Impairment: IAS 36..................................................................................................... 197
Research and development......................................................................................... 198
International differences............................................................................................. 200
Reminder of learning outcomes.................................................................................. 201
Sample examination question..................................................................................... 201
Chapter 9: Accounting for inventories and construction contracts.................... 203
Aims of the chapter.................................................................................................... 203
Learning outcomes..................................................................................................... 203
Essential reading........................................................................................................ 203
Further reading........................................................................................................... 203
Components of inventory............................................................................................ 203
Implications of inventory for the accounts................................................................... 204
Inventory valuation: definitions .................................................................................. 206
Implications of fair value accounting........................................................................... 208
Construction contracts................................................................................................ 208
Profit recognition methods.......................................................................................... 208
Reminder of learning outcomes.................................................................................. 213
Sample examination question .................................................................................... 213
Chapter 10: Accounting for equity and liabilities............................................... 215
Aims of the chapter.................................................................................................... 215
Learning outcomes..................................................................................................... 215
Essential reading........................................................................................................ 215
Further reading........................................................................................................... 215
Share capital and reserves.......................................................................................... 216
Ordinary shares.......................................................................................................... 216
Preference shares....................................................................................................... 216
Accounting issues: equity or liability?.......................................................................... 217
Off-balance sheet financing........................................................................................ 225
Reminder of learning outcomes.................................................................................. 226
Sample examination questions.................................................................................... 227
Chapter 11: Accounting for taxation................................................................... 229
Aims of the chapter.................................................................................................... 229
Learning outcomes..................................................................................................... 229
Essential reading........................................................................................................ 229
Further reading........................................................................................................... 229
An introduction to corporation tax systems................................................................. 230
UK: corporation tax.................................................................................................... 230
Deferred taxation: taxable profit versus accounting profit............................................ 233
Three approaches to the accounting treatment of deferred tax.................................... 235
Value-added tax (VAT)................................................................................................ 238
Reminder of learning outcomes.................................................................................. 238
Sample examination question..................................................................................... 239
Chapter 12: Analysis and interpretation of financial reports.............................. 241
Learning outcomes..................................................................................................... 241
Essential reading........................................................................................................ 241
Further reading........................................................................................................... 241
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Contents
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AC3091 Financial reporting
Notes
vi
Introduction
Introduction
Learning outcomes
At the end of this course and having completed the Essential readings and
activities, you should be able to:
• explain and apply a number of theoretical approaches to financial
accounting
• record and analyse data
• prepare financial statements under alternative accounting conventions
• describe a number of regulatory issues relating to financial accounting
• critically evaluate theories and practices of, and other matters relating
to, financial accounting.
The learning outcomes that you are expected to achieve for the various
topics are listed at the end of each chapter.
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AC3091 Financial reporting
Syllabus
The rationale for financial reporting. Arguments for and against regulation
of financial reporting. Methods of regulation, including standardisation of
accounting practices. The nature and purposes of a conceptual framework
for financial reporting: the objectives of financial reporting; the qualitative
characteristics of accounting information; the definitions of an asset
and a liability; recognition and measurement in financial statements;
international framework. Narrative reporting and issues of corporate social
responsibility. Economic and accounting concepts of income, capital and
value with particular reference to Hicks’s income concepts.
Strengths and weaknesses of historical cost accounting. Bases of
asset valuation. Capital maintenance concepts and various associated
techniques: current value accounting systems, current purchasing power
accounting, replacement cost accounting; in addition to entry (historical
cost) and exit value accounting.
Accounting for investments and groups of companies. The merger and
acquisition methods. Associated companies and joint ventures. Accounting
for foreign currency transactions, foreign subsidiaries and branches: the
temporal and closing rate/net investment methods of foreign currency
translation.
Accounting for tangible and intangible assets: fixed assets and
depreciation; stocks and long-term contracts; research and development;
goodwill. Accounting for leases. Accounting for liabilities. Accounting for
taxation, including deferred taxation.
Analysis and interpretation of corporate financial reports; introduction to
international differences in financial reporting.
2
Introduction
Websites
It is also recommended that you use the internet and investigate the
different professional bodies and government organisations’ websites
which are a useful source of information on current developments in
financial reporting and regulation. Examples include:
• www.frc.org.uk for the UK Accounting Standards Board (ASB)
• www.fasb.org for the US Financial Accounting Standards Board (FASB)
• www.iasb.org.uk for the International Accounting Standards Board
(IASB).
Unless otherwise stated, all websites in this subject guide were accessed in
April 2012. We cannot guarantee, however, that they will stay current and
you may need to perform an internet search to find the relevant pages.
Activities
This subject guide is divided into 12 chapters, the majority of which are
self-contained. Most chapters contain worked numerical examples, where
appropriate, and activities appear throughout the guide. It is strongly
recommended that you attempt to answer, or consider the implications of,
all activities. Many of them require you to do additional reading. Solutions
to some of the activities and sample examination questions are available in
Appendix 1 at the back of the guide.
Reading advice
There is no single wholly satisfactory textbook covering all the topics
discussed in this course. References are given to one of the main advanced
financial accounting textbooks. References for specific Further reading will
also be given where appropriate. You are advised to check if new editions
of these textbooks are available.
Essential reading
Alexander, D., A. Britton and A. Jorissen International Financial Reporting
and Analysis. (Andover: Cengange Learning EMEA, 2011) fifth edition
[ISBN 9781408032282]. Hereafter, we will refer to this book simply as
International Financial Reporting.
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AC3091 Financial reporting
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed below. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the VLE regularly for updated guidance on readings.
Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the VLE and University of London
Online Library (see below).
Other useful texts for this course include:
Collins, B. and J. McKeith Financial Accounting and Reporting. (London:
McGraw-Hill, 2010)[ISBN 9780077114527].
You might find it helpful to refer to a dictionary of accounting when you
encounter a new term. Two such dictionaries are:
Nobes, C. The Penguin Dictionary of Accounting. (London: Penguin Books Ltd,
2006) second edition [ISBN 9780141025254].
Owen, G. Dictionary of Accounting. (Oxford: Oxford University Press, 2005)
third edition [ISBN 9780192806277].
It is also recommended that you purchase or have access to the following
reference texts:
Deegan, C. and J. Unerman Financial Accounting Theory. (London: McGraw-
Hill, 2011) second European edition [ISBN 9780077126735].
Glautier, M.W.E., B. Underdown and D. Morris Accounting Theory and Practice.
(Harlow: Financial Times Prentice Hall, 2011) eighth edition [ISBN
9780273693857]. Please note that this is the Essential reading for 25
Principles of accounting so you may already own a copy.
Lewis, R. and D. Pendrill Advanced Financial Accounting. (Harlow: Financial
Times Prentice Hall, 2004) seventh edition [ISBN 9780273658498].
Palepu, K.G., and P.M. Healy Business Analysis and Valuation: Using Financial
Statements. (Mason, OH: Thomson South-Western, 2008) fourth edition
[ISBN 9780324302929].
Suitable international texts for reference include:
Nobes, C. and R. Parker Comparative International Accounting.
(Harlow: Financial Times Prentice Hall, 2012) twelfth edition
[ISBN 9780273763796].
Choi, F.D. and G.K. Meek International Accounting. (Harlow: Pearson, 2012)
seventh edition [ISBN 9780132311496].
Those of you who have studied 25 Principles of accounting may find
it useful to keep your subject guide to hand as you study this course.
The following is a list of all other reading listed in the Further reading
category in the subject guide:
Baxter, W.T. Depreciation. (London: Sweet & Maxwell, 1971)
[ISBN 042114470X].
Baxter, W.T. Inflation Accounting. (Oxford: Philip Allan, 1984)
[ISBN 9780860036234] Chapters 3, 8 (pp.103–15) and 12 (pp.182–201).
Beaver, W.H. and J.S. Demski ‘The Nature of Income Measurement’, Accounting
Review 54(1) 1979.
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Introduction
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AC3091 Financial reporting
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
• Electronic study materials: All of the printed materials which you
receive from the University of London are available to download, to
give you flexibility in how and where you study.
• Discussion forums: An open space for you to discuss interests
and seek support from your peers, working collaboratively to solve
problems and discuss subject material. Some forums are moderated by
an LSE academic.
• Videos: Recorded academic introductions to many subjects;
interviews and debates with academics who have designed the courses
and teach similar ones at LSE.
• Recorded lectures: For a few subjects, where appropriate, various
teaching sessions of the course have been recorded and made available
online via the VLE.
• Audiovisual tutorials and solutions: For some of the first year
and larger later courses such as Introduction to Economics, Statistics,
Mathematics and Principles of Banking and Accounting, audio-visual
tutorials are available to help you work through key concepts and to
show the standard expected in exams.
• Self-testing activities: Allowing you to test your own
understanding of subject material.
• Study skills: Expert advice on getting started with your studies,
preparing for examinations and developing your digital literacy skills.
6
Introduction
Note: Students registered for Laws courses also receive access to the
dedicated Laws VLE.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
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AC3091 Financial reporting
8
Introduction
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AC3091 Financial reporting
EU European Union
FASB Financial Accounting Standards Board
FIFO first-in, first-out
FPPFS Framework for the Preparation and Presentation of Financial Statements
FRS Financial Reporting Standard
GPP General Purchasing Power
HCA Historical Cost Accounting
IAS International Accounting Standard
IASB International Accounting Standards Board
IASC International Accounting Standards Committee
IFRS International Financial Reporting Standard
IOSCO International Organization of Securities Commissions
LIFO last-in, first-out
NBV net book value
NPV net present value
NRV net realisable value, also known as ‘current exit value’
P/E price/earnings ratio
PV present value, also known as ‘economic value’
RC replacement cost, also known as ‘current entry cost’
ROCE return on capital employed
RPI Retail Price Index
SEC Securities and Exchange Commission
SOP Statement of Principles
SSAP Statement of Standard Accounting Practice
10
Chapter 1: Rationale for financial reporting and its regulation
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• delineate the basic character of financial accounting theory
• discuss the role of accounting in society
• explain the different levels of authority in the UK regulatory
framework
• explain and discuss the implications of the International Accounting
Standards Board (IASB)
• discuss the arguments for and against accounting standards
• discuss the theory of regulation.
Essential reading
International Financial Reporting, Chapter 1.
Further reading
Baxter, W.T. ‘Accounting Standards – Boon or Curse’, Accounting and Business
Review, Winter 1981, pp.3–10.
Beaver, W.H. Financial Reporting: An Accounting Revolution. (Harlow: Prentice-
Hall, 1981) [ISBN 9780133161335]. Chapter 7.
Bromwich, M. Financial Reporting, Information and Capital Markets. (London:
Pitman Publishing, 1992) [ISBN 9780273034643]. Chapters 10 and 11.
Cadbury report (1992); this can be viewed on the internet. See the website for
the Institute of Internal Auditors: www.iia.org.uk followed by a search for
‘Cadbury report’.
Deegan, C. and J. Unerman Financial Accounting Theory. (London: McGraw-
Hill, 2011) second European edition [ISBN 9780077126735] Chapters 1–4.
Gallhofer, S. and J. Haslam, ‘Exploring social, political and economic
dimensions of accounting in the global context: the IASB and accounting
disaggregation’, Socio-Economic Review 8(4) 2007, pp. 633–64.
Lewis, R. and D. Pendrill Advanced Financial Accounting. (Harlow: Financial
Times Prentice Hall, 2004) seventh edition [ISBN 9780273658498]
Chapters 1–3.
Scott, W. Financial Accounting Theory. (London: Prentice-Hall, 2011)
[ISBN 9780135119150].
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AC3091 Financial reporting
In this subject guide we give insights into the more prescriptive and the
more descriptive approaches. Again, there are different approaches within
this broad categorisation. For instance, there are those who draw primarily
from economics in formulating either prescriptive or descriptive theories of
accounting. And one should note here that there are different views within
economics! Others draw from sociology or adopt a more interdisciplinary
perspective. The latter approach overlaps with concerns to understand
financial accounting more broadly and especially in terms of its scope, the
variety of influences upon it and its diverse consequences. Many academics
and policy-makers consider mainstream economic theory to be a good
basis for theorising financial accounting prescriptively and descriptively
while for others it is a narrow approach that does not take into account
the actual and potential repercussions of financial accounting. We shall try
to give insights into major instances of the more economistic approaches
and other approaches and also here try to build bridges between them.
We shall thus begin to explore how accounting’s role has been variously
theorised prescriptively, e.g. as improving economic decisions so as to
enhance social welfare or as contributing to a better democracy and shall
consider descriptive studies of accounting so as to also reflect the diverse
approaches of the literature.
In this chapter we consider prescriptive views that have emerged in
relation to issues of accounting’s regulation. We shall see that many views
here reflect mainstream economistic thinking. We offer descriptions of
financial accounting practice and its context in the UK and internationally,
with again an emphasis on how financial accounting is regulated. It
becomes clear here that a mainstream economistic thinking has been
influential in the construction of a regulatory framework with linked
institutions in this area. We also give some attention to ways of seeing
beyond the economistic.
regulation). Further, users will tend to overstate their desire for disclosure
if they do not have to pay for it (although indirectly they may bear costs).
The costs will be borne by those supplying the information.
History does indicate that companies will voluntarily disclose at least
some information (at least they will disclose some information under
other pressures). While those observing practice historically admit to
some evidence of this type of market-induced effect, substantively they
point to weak financial accounting here and the case for regulating
financial accounting in terms of state and/or state-backed or quasi-state
professional regulation, beyond the more liberal approach. The view here
is that the market for information is such that without interventionist
regulation a sub-optimal amount of information will be produced. And the
comparability it facilitates may be less than desirable. The case for likewise
regulating notions of broader corporate social responsibility accounting is
similar. This said, contexts vary and a great deal of pressure may be placed
on business (e.g. by competitive forces, a strong civil society) without
legislation or quasi-law.
Under the contracting arguments, the actual cost of enforcing the
individual contracts or ‘group contracts’ would be higher than those
costs associated with state and/or state-like regulation. Even with these
contracts there would be a need for comparability of accounting practices.
A number of related arguments for regulation have been suggested,
reflecting the assumption of an imperfect markets context, including the
following:
• Left unregulated as envisaged, market forces would ‘lead to an
uneven possession of information among investors’. Consequently the
regulation would provide an equitable solution. ‘It is only fair that the
less informed be protected from the more informed.’ Some have more
power than others (over others) in terms of accessing information.
• Accounting information shares the characteristics of a public good, and
therefore suffers the same problems of externalities and free riders.
Under these conditions the absence of the regulation envisaged could
result in the under provision of information.
• Managers have incentives not to disclose unfavourable information.
Consequently investors would be unable to distinguish good
companies from bad ones, resulting in ‘adverse selection’. Further,
investors need protection from the fraudulent, which would actually
produce misleading information. Due to information asymmetries, the
disclosures may not obviously be seen as fraudulent.
Others argue markets are not so speedy in re-adjusting to changes. If
they may keep returning to reasonable positions or an equilibrium (a
contestable view for some), people may get hurt in the process, given its
slow speed. Indeed this may be in ways they can scarcely be compensated
for.
The ‘balanced’ view on financial accounting discussed above may be
taken as implying that regulation to improve transparency should not
be universally overly strict, or it might imply the need for a regulation
that has limits and that might be set so as to prevent firms competing
in the market place in terms of information disclosure, which may drive
disclosure towards too much transparency. In an imperfect markets
context, a particular level of disclosure or transparency would be optimal
for social welfare. A degree of secrecy or confidentiality is required
16
Chapter 1: Rationale for financial reporting and its regulation
to allow the system to function for the best (e.g. create incentives for
research and development, discourage monopolistic practice that might
be encouraged through information sharing). A degree of transparency
is required to facilitate financing and the better allocation of resources.
The regulation envisaged may bring this balanced disclosure about better.
Markets functioning without that may lead to ‘beggar-my-neighbour’
disruptive forms of competition in respect of disclosure.
Some analysts of the issues have used game theory as a framework and
tried to model (appreciating the possibility of audit) external financial
accounting disclosures in relation to the incentives of regulators and
corporate managers (e.g. incentives to disclose or hide, to be honest or
dishonest). From this quasi-descriptive modelling (to which dimensions of
uncertainty and the costliness of information can be built in) an attempt
is made to see if answers can be found to questions such as: Is rigid
regulation better than flexible regulation? Is mandatory disclosure better
than a looser more voluntary approach? This framework can enhance
appreciation of the character and feasibility of actual and potential
regulatory forms, although it is not straightforward to translate this into
social welfare implications in an imperfect markets and imperfect societal
context.
Activity 1.1
Read Beaver (1981) Chapter 7 and Gallhofer and Haslam (2007), taking notes.
Critically appraise the main arguments that Beaver puts forward for increased regulation.
How do Gallhofer and Haslam (2007) see accounting regulation?
Type 2: Uniformity of presentation. This type of standard would only concern rules
on how you should present your financial results and hence create some
form of uniformity and consistency.
In terms of the earlier argumentation, the more detailed and the less
flexible the requirements then the stronger the regulation.
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AC3091 Financial reporting
when in fact a standard principle may still leave room for different
estimates). Consequently investors and other users need to be
educated about this.
• If they do not take account of possible economic consequences,
standards may result in adverse allocation effects. Accounting
standards might result in sub-optimal behaviour purely to ensure that
accounting earnings are not reduced.
• Standards could result in overload, e.g. if there are too many
standards; if standards are too detailed; if standards are not specific
enough; if there are too many standard-setters.
Activity 1.2
What criteria are relevant in deciding upon accounting standards? Should standards
specify the detail or be more in the nature of general guidelines?
20
Chapter 1: Rationale for financial reporting and its regulation
In the above respect, the Act makes it clear that the true and fair
requirement is overriding.
If in special circumstances compliance with any of those
provisions is inconsistent with the requirement to give a true and
fair view, the directors shall depart from that provision to the
extent necessary to give a true and fair view. Particulars of any
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AC3091 Financial reporting
such departure, the reasons for it and its effect shall be given in
the note to the accounts.
(Section 226(5))
22
Chapter 1: Rationale for financial reporting and its regulation
Accountancy
Accounting Auditing Board for Professional Financial
Investigation
Standards Practices Actuarial Oversight Reporting
and Discipline
Board Board Standards Board Review Panel
Board
Committee on
Urgent Corporate
Issues Governance
Task Force
Executive
Figure 1.1 Organisational chart for the accounting standard-setting body in the
UK. Source: www.frc.org.uk/about/chart.cfm
It has been authorised under the Companies Act to make application to the
court for a declaration that a company’s annual accounts do not comply
with the requirements of the Companies Act and for an order that the
directors prepare revised accounts. (See below.)
• Accounting Standards Board (ASB)
Established in August 1990, this replaced the ASC. It is an expert body
to develop, issue and withdraw accounting standards, with a full-time
chairman and technical director and 10 members in total (originally
nine). It also has a large full-time secretariat. It issues Financial
Reporting Standards (FRS) on its own authority, on a
two-thirds majority. A committee of the FRC appoints its members.
The ASB has stated its aims as follows:
to establish and improve standards of financial accounting and
reporting, for the benefit of users, preparers and auditors of
financial information.
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Chapter 1: Rationale for financial reporting and its regulation
• The Companies Act 1989 inserted a new paragraph 36A into Schedule
4 of CA 1985. This requires it to be stated whether the accounts have
been prepared in accordance with applicable accounting standards,
with particulars of any material departure from those standards and
reasons for these to be given.
• Section 12 of the Companies Act 1989 inserted a new section (s.254B)
into CA 1985 giving the Secretary of State power to apply to the court
for a declaration that a company’s annual accounts do not comply
with the requirements of the Act and for an order that the directors
prepare revised accounts. The Secretary of State may also authorise
a person for this purpose and, as noted above, has authorised the
Financial Reporting Review Panel (FRRP) to make such applications.
If the court finds against the company, it may order that application
costs and reasonable expenses of the company in connection with (or
in consequence of) preparing revised accounts shall be borne by the
directors who were party to approving the defective accounts.
Note that the power to apply to the courts relates to non-compliance with
the Act’s requirements rather than specifically with standards. This then
raises the question of the relationship between accounting standards and
the requirement for accounts to show a true and fair view. Below is the
professional opinion of Mary Arden QC:
Compliance with accounting standards will normally be
necessary for Financial Statements to give a true and fair view…
The requirement to give a true and fair view may in special
circumstances require a departure from accounting standards…
If in exceptional circumstances compliance with an accounting
standard is inconsistent with the requirement to give a true and
fair view, the requirement of the accounting standard should be
departed from to the extent necessary to give a true and fair view.
(Appendix to Foreword to Accounting Standards, ASB, 1993)
Mary Arden QC stated that whether accounts satisfy true and fair
requirements is for the courts to decide, but they will look to the practices
and views of accountants; the more authoritative these are, the more the
courts will be ready to follow them.
Just as a custom which is upheld by the courts may properly
be regarded as a source of law, so too, in my view, does an
accounting standard which the court holds must be complied
with to meet the true and fair requirement become, in cases
where it is applicable, a source of law in itself in the widest
sense of that term.
(Mary Arden QC, ‘The True and Fair requirement’.)
The Companies Act 2006 implemented some of the proposals of the
Company Law Review (see Activity 1.4).
Stock Exchange
The London Stock Exchange also lays down regulations concerning listed
companies’ published accounts. The regulations require the provision of
more information, and more frequently, than either the law or the UK
ASB or the IASB requires. For example, companies are required to publish
interim accounts and provide more detail regarding certain liabilities (e.g.
bank loans).
In 1995 the International Organization of Securities Commissions (IOSCO)
agreed to a review of IASs, with a view to endorsing IASs for cross-border
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AC3091 Financial reporting
Activity 1.3
In the UK, the Stock Exchange was one of the earliest sources of rules and regulations
relating to financial statements. In many other countries, the rules and regulations of the
relevant stock exchange are important.
a. Why do stock exchanges take such an interest in rules and regulations relating to
financial statements?
b. What are the main requirements of the stock exchange in your country?
Activity 1.4
The Company Law Review was set up to examine the whole framework of company
law. Study its recommendations: Company Law Reform. Modern Company Law for a
Competitive Economy: Developing the Framework, which can be found at:
www.berr.gov.uk/files/file23245.pdf.
A Companies Act was introduced in 2006. To what extent did it implement the
recommendations?
26
Chapter 1: Rationale for financial reporting and its regulation
Question 1.2
What factors should be considered in deciding upon the form of
accounting regulation?
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AC3091 Financial reporting
Notes
28
Chapter 2: Conceptual framework
Essential reading
International Financial Reporting, Chapter 8.
Accounting Standards Board, 1999, Statement of Principles for Financial
Reporting. (Reproduced in Accountancy, March 2000, pp.109–38). See
below for the ASB website.
Websites
See also the following websites:
www.frc.org.uk/asb/technical/principles.cfm
www.iasb.org.uk/ then follow links to summaries of international financial
reporting standards
Further reading
Bromwich, M. Financial Reporting, Information and Capital Markets. (London:
Pitman Publishing, 1992) [ISBN 9780273034643]. Chapter 12 (Although
this focuses specifically on the FASB’s conceptual framework, it also
discusses a number of issues about the conceptual framework approach that
can be considered in relation to the IASB’s FPPFS and the ASB’s Statement
of Principles.)
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AC3091 Financial reporting
Relevant UK standards
The Statement of Principles.
FRS 18 Accounting Policies (replaced SSAP 2 Disclosure of Accounting Policies).
30
Chapter 2: Conceptual framework
Although these questions are fundamental, the extent to which they have
been addressed varies among countries. However, in general:
31
AC3091 Financial reporting
Although the main purpose of the SOP is to help set accounting standards,
the Introduction to it notes that, due to other factors to be considered
when setting standards (including legal requirements and cost/benefit
considerations), a standard may still adopt an approach different from
that suggested by the principles. The SOP has not been developed within
the constraints imposed by company law so it may contribute to the future
development of law.
33
AC3091 Financial reporting
The FASB then asserts that what investors want are balance sheets
and income statements: inductively from the fact that this is what they
currently actually get and politically because the FASB has no intention of
undermining the very basis of present practice and thus has rationalised
accrual accounting.
However, the FASB has actually steered away from trying to identify the
kind of information that may assist users (e.g. current value information,
management forecasts, etc.)
In the UK, the ASB’s SOP states that the objective is to provide information
about the financial performance and financial position of an entity which
would be useful to a wide range of users in assessing the stewardship of
managers.
The ASB has selected the investor’s perspective as the one most likely to
help in the preparation of general-purpose financial statements. It states
that, whilst recognising a large number of potential users of financial
statements, who usually require different information for the different
decisions they must make, a statement based on such a perspective focuses
on the common interest of all users – the entity’s cash-generating
ability and financial adaptability. It therefore focuses on present
and potential investors as the defining class of user, arguing that in
meeting their needs financial statements will meet the common needs of
other users. It notes that information that is not needed by investors need
not be given in the financial statements.
The SOP details the information required by investors, which is very
similar to the FASB, and is said to comprise the following:
• In relation to financial performance: the return obtained on its
resources, the components of that return and the characteristics of
those components.
• In relation to financial position: the economic resources controlled by
the entity, its financial structure, liquidity and solvency, risk profile and
risk management approach, and capacity to adapt to changes in the
environment.
• Information about the generation and use of cash, which provides a
further perspective on financial performance.
34
Chapter 2: Conceptual framework
Activity 2.1
Do you think that the investor’s perspective is the most appropriate?
With reference to a selected ‘conceptual framework’, satisfy yourself that you are aware
of the range of stated objectives of financial reporting.
35
AC3091 Financial reporting
User-specific Understandability
qualities
Decision usefulness
Primary
decision-specific Relevance Reliability
qualities
Ingredients
of primary Predictive Feedback Timeliness Verifiability Representational
qualities value value faithfulness
Secondary and
interactive Comparability Neutrality
qualities (including consistency)
Threshold for
recognition Materiality
Predictive Confirmatory Faithful Neutral Free Complete Prudence Consistency Disclosure User’s Aggregation
value value representation from abilities and
material error classification
Materiality
To begin with there must be some assessment of whether the information
is material (i.e. could this information influence users’ decisions?).
Materiality is viewed as a threshold characteristic because if any
information is immaterial then users are not interested in it whatever
other characteristics it has. Immaterial information should not be given
as this may impair understanding of the financial statements. But what is
material? Does the assessment of materiality vary between users?
36
Chapter 2: Conceptual framework
Relevance
The FASB defines relevance as the capacity of information to make a
difference in a decision by helping users to form predictions about the
outcomes of past, present and future events to confirm or correct prior
expectations. Similarly the ASB defines relevant information as that which
is able to ‘influence the economic decisions of users and is provided in
time to influence those decisions.’
Reliability
The ASB states that reliable information is:
• faithful representation (i.e. it can be depended upon to represent
what it purports to represent or could reasonably be expected to
represent – reflects the substance of a transaction or event)
• free from deliberate or systematic bias (i.e. is neutral)
• complete and free from material error
• prepared on a prudent basis (i.e. under conditions of uncertainty,
a degree of caution has been exercised in making the necessary
judgements or estimates).
The FASB states:
To be reliable, financial statements must portray the important
relationships of the firm itself. Information is reliable if it is
verifiable and neutral and if users can depend on it to represent
that which it is intended to represent.
Comparability
The ASB states that comparability enables users to discern similarities in
and differences between the effect and nature of transactions and events
between entities, and over time for the same entity (very similar to the
FASB definition). It requires consistency and disclosure of accounting
policies. The SOP notes, however, that consistency should not prevent the
introduction of improved accounting policies.
Understandability
To be useful, information must be understandable. This depends on the
way in which it is aggregated, classified and presented, and on the ability
of users (who are presumed to have reasonable knowledge of business
and accounting and are prepared to study the information with reasonable
diligence).
Conservatism/prudence
In the FASB hierarchy of accounting qualities, conservatism does not
appear within the diagram, unlike prudence for the ASB. The FASB
statement notes that there is a place for conservatism in financial
reporting, but that if it is not applied with care it may conflict with
qualitative characteristics such as neutrality and representational
faithfulness by introducing bias. Conservatism should not imply deliberate,
consistent understatement of profit and net assets; rather it requires that
adequate consideration be given to the risks and uncertainty attached
to business situations. Similarly the ASB states that prudence is only
necessary in conditions of uncertainty and should not be used for
deliberate overstatement of liabilities/losses or deliberate understatement
of assets/gains, nor to create excessive provisions or hidden reserves.
37
AC3091 Financial reporting
Further comments
Does spelling out what is meant by ‘useful’ get us very far? For Macve
(1981): ‘many other studies have identified desirable attributes but have
not led to greater agreement in practice about particular problems and it
shifts the area of disagreement from ‘is this information useful?’ to ‘is this
reliable?’ or ‘is this relevant?’ and may merely lead to ‘wordshuffling’. But
the analysis may help us identify some reasons for disagreement (e.g. ‘this
proposed treatment does not have predictive value/confirmatory value/
faithful representation’).
It has been suggested that the definition of ‘reliable’ is circular:
information is reliable if it can be depended upon to represent what it
purports to represent (i.e. it is reliable if it is reliable).
Bromwich (1992) points to two problems with the use of predictive value
in the FASB conceptual framework projects:
It has not made explicit the decision model it sees investors using.
It has not shown how accounting information can obtain predictive value.
Activity 2.2
1. Often an accounting standard will have to make a trade-off between reliability and
relevance:
a. What is the difference between reliability and relevance?
b. How should accounting standards rank these two qualitative characteristics?
c. Which user groups need to be considered when determining the relative
importance of reliability and relevance?
2. Other qualitative characteristics might be important. Discuss how timeliness,
objectivity, verifiability and neutrality might fit in with characteristics we have
described already.
3. The benefits from reporting accounting information should exceed the costs. How
easy (or difficult) do you think it is to quantify the costs and benefits of an accounting
item?
38
Chapter 2: Conceptual framework
39
AC3091 Financial reporting
Further comments
Are the definitions useful, given that they are sufficient but not necessary
conditions for the inclusion of an item in the financial statements?
Macve (1981) points out that the definitions are so general that they are
unlikely to exclude anything that one might reasonably want to include.
Indeed, the FASB statement itself points out that it expects most assets
and liabilities in the present practice to continue to qualify as assets or
liabilities under the definitions, and that the definitions neither require nor
presage upheavals in present practice.
Note that these definitions do not depend on legal enforceability. But how
far removed from a legal one might a right or claim be? Is it a question of
the probability of future benefits or sacrifice of future benefits? But how
probable is probable? (The FASB statement notes that probable is used
with its ‘usual general meaning’, referring to ‘that which can reasonably
be expected or believed on the basis of available evidence or logic but is
neither certain nor proved.’) What is a past transaction? What gives rise to
the existence of an asset or liability?
These are some of the recognition problems that the statements do
not help with, but which are particularly important for executory
contracts3 – that is, a promise for a promise, for example an agreement 3
See below for further
to sell goods at a future date in return for payment at a future date. The discussion.
‘Elements’ chapter in the ASB statement says that rights and obligations
40
Chapter 2: Conceptual framework
Activity 2.3
What do the definitions of assets and liabilities above actually mean? Explain in your own
words.
Recognition
Recognition deals with those items that should appear in the financial
statements. The ASB states:
The objective of financial statements is achieved to a large
extent through depicting in the primary financial statements, in
words and by a monetary amount, the effects that transactions
and other events have on the elements. This process is known as
recognition.
The criteria for initial recognition of an element5 in the SOP are that: 5
The elements of
financial statements are
1. There is sufficient evidence that the change in assets or liabilities those discussed above
inherent in the element has occurred (including, as appropriate, such as assets, liabilities,
evidence that a future beneficial inflow or outflow will occur). ownership interest, gain
and so on.
2. The element can be measured as a monetary amount with sufficient
reliability.
Similarly the FASB sets out four fundamental recognition criteria:
1. meeting the definition of an element
2. measurability – having a relevant attribute which is measurable with
sufficient reliability
3. relevance
4. reliability.
The ASB’s SOP points out that although the starting point for the
recognition process may be the effect on assets and liabilities, the notions
of ‘matching’ and the ‘critical event’ may help in identifying the effects.
However, the SOP emphasises that ‘matching’ is not used to drive the
recognition process. It seeks to prevent unrestricted use of the matching
concept, otherwise it would be possible to delay recognition in the
performance statement of most items of expenditure whose hoped-for
benefits lay in the future. It restricts this by allowing only items that meet
41
AC3091 Financial reporting
The concept of realisation does not appear amongst the criteria for
recognition in the SOP. In Appendix III the Board points out that, over
time, even wider notions of ‘realisation’ have become irrelevant and, rather
than choosing to ‘bend a term so that it has meaning other than its natural
meaning’, the Board has chosen to focus on the underlying objective of
recognising a gain only if there is reasonable certainty that it exists and
can be measured reliably. ‘Although the realisation notion is one means of
determining whether the existence of a gain is reasonably certain… in the
Board’s view it is not necessarily the best way.’ In Appendix I the Board
points out that although this appears to conflict with the Companies Act
(which states that only profits realised at the balance sheet date may be
included in the income statement), ‘the way in which the Act defines a
realised profit means that the exact effect of this difference is not clear.’
However, the FASB states that to recognise revenues and gains the items
should be (a) realised or realisable and (b) earned.
Activity 2.4
What typically gives rise to ‘change’ needing to be considered for recognition?
If there is a change in an asset which is not offset by a change in a liability then where
should the gain or loss be recognised? What are the conditions under which gains can be
recognised in the income statement either in the UK or internationally?
Measurement
Assuming that financial items satisfy the recognition criteria, at what
amount should they be recorded in the financial statements? Should
they be at cost, at market value or at some other amount? There are a
number of different theoretical approaches to measurement, for example
replacement cost or deprival value. Many of the different approaches
are reviewed in this subject guide. The underlying argument regarding
measurement is that there is no single valuation method that can
meet all financial reporting purposes in all circumstances.
In the US, SFAC No. 5 dealt more with current practices than actual
recommendations (and it received much criticism). For instance, it did
not prescribe a particular measurement attribute to be used in given
circumstances. Instead it listed five measurement attributes used in
practice:
42
Chapter 2: Conceptual framework
• historical cost
• current cost
• current market value
• net realisable value
• present value of future cash flows.
It concluded that ‘rather than attempt to select a single attribute and
force changes in practice… this statement suggests that use of different
attributes will continue.’ It notes that an ideal measuring unit would be
stable over time but suggests that at times of low inflation nominal units
of money are relatively stable; ‘the Board expects that nominal units of
money will continue to be used to measure items recognised in financial
statements’ but suggests that this might change if increased inflation
led to ‘intolerable’ distortions. This is similar to the ASB who note that
although most financial statements are prepared using the financial capital
maintenance concept and measured in nominal units, adjustments will
be needed if the problem of general price change is acute, and if the
problem of specific changes is acute ‘it will be necessary to adopt a
system of accounting that informs the user of the significance of specific
price changes for the entity’s financial performance and financial position.’
Little in the FASB statement is likely to lead to a change from existing
US practice. Indeed, it largely reaffirms it. Paragraph 2 notes that ‘the
recognition criteria and guidance in the Statement are generally consistent
with current practice and do not imply radical change’ (though it notes the
possibility of future change is not foreclosed – see also paragraph 91).
However, the ASB states, in Chapter 6 of the SOP, that the measurement is
based on the assumption that a ‘mixed measurement’ approach (often
referred to as ‘modified historical cost’)7 will be adopted, whereby 7
The ASB (1999)
some items will be measured at historical cost and others at current states that although
the measurement
value. It suggests that ‘the basis selected will be the one that best meets
basis noted above is
the objective of financial statements and the demands of the qualitative often referred to as
characteristics of financial information, bearing in mind the nature of the the ‘modified historical
assets or liabilities concerned and the circumstances involved.’ cost basis’, it is more
accurately referred to as
Following initial recognition, items will be remeasured, as necessary, to
the ‘mixed measurement
ensure that items measured at historical cost are carried at the lower of system’.
cost and recoverable amount, and items shown at current value are kept
up-to-date.
The statement asserts that ‘current value is at its most relevant when it
reflects the loss that the entity would suffer if it were deprived of the asset
involved’ and therefore advocates a measurement basis known as ‘value to
the business’ or ‘deprival value’, depicted diagrammatically in Figure 2.3.
(The concept of deprival value will be discussed in more detail later in the
subject guide.)
Value to the business
= lower of:
43
AC3091 Financial reporting
The SOP notes that the ‘relief value’ of a liability may be selected in a
similar manner.
It stops short of advocating a move towards current value accounting:
[I]t says nothing about the desirability or otherwise of adopting
an approach that involves all balance sheet items being
measured at current value, just as it says nothing about the
desirability or otherwise of adopting an approach that involves
all balance sheet items being measured at historical cost. All it
does say is that both these approaches would involve a radical
change to existing practice.
(ASB, 1999)
However, in discussing the choice of a measurement basis it makes the
following points:
• As markets develop, measurement bases once thought unreliable may
become more reliable.
• The need for relevant information means that the measurement basis
should be one that provides information useful for assessing the
entity’s ability to generate cash flows and its financial adaptability.
• If both historical cost and current value measures are available, the
better one to use will be the one that is more relevant.
• Current value measures are not necessarily less reliable than historical
cost measures; for example provisions for bad and doubtful debts
under historical cost accounting involve estimates similar to (and of
similar reliability to) those involved in ascertaining current values not
derived from an active market.
• ‘Assessment of relevance and reliability needs to take into account
what the asset or liability represents.’ It suggests that an investment
which represents a ‘store’ of spare cash will best be measured at
current value since its relevance to the entity will be the future cash
flows that it represents right to.
An earlier exposure draft of the SOP was criticised by many as being an
attempt to introduce a current cost accounting system. The SOP
appears to play down the importance of fully blown, current-cost systems
by suggesting that a mixed measurement system will continue
to be used, though it refers to many advantages of current value. The
statement refers to choosing the most relevant basis when both historical
cost and current value are available and reliable, and the need to choose
a measurement basis according to the nature of the assets, the particular
circumstances, the objectives of financial statements and the qualitative
characteristics of financial information. But can the mixed measurement
system be justified in terms of ‘principles’? It also raises questions of
comparability. Baxter comments that ‘such muddled figures hardly add to
accounting dignity’.8 8
Accountancy, October
1999.
44
Chapter 2: Conceptual framework
45
AC3091 Financial reporting
Conclusions
The ASB’s Statement of Principles in many respects resembles much of
the existing practice. However, the SOP has played a significant role in
the development of new Financial Reporting Standards (FRSs). As the
ASB states ‘…all the standards that have been issued since then [i.e.
after the SOP] are therefore based on those principles. Indeed, some
of the principles play very significant roles in those standards [i.e. new
standards]. For example:
• FRS 2 Accounting for Subsidiary Undertakings uses the reporting entity
concept described in Chapter 2 of the statement
• FRS 4 Capital Instruments, FRS 5 Reporting the Substance of
Transactions, FRS 7 Fair Values in Acquisition Accounting, FRS 12
Provisions, Contingent Liabilities and Contingent Assets, FRS 19 Deferred
Tax, FRS 26 Financial Instruments: Recognition and Measurement all
use the definition of assets and liabilities (where applicable) set out in
Chapter 4;
• FRS 11 Impairment of Non-Current Assets and Goodwill uses the
recoverable amount notion described in Chapter 6; and
• FRS 3 Reporting Financial Performance draws on the principles of good
presentation described in Chapter 7.
• FRS 18 Accounting Policies and FRS 28 Corresponding Amounts draws
on the qualitative characteristics of accounting information set out in
Chapter 3.’
However the one major difference with existing practice revolves around
the notion of ‘matching’. An earlier draft was also criticised for appearing
to downgrade the importance of ‘matching’ in the accounting process.
Many commentators saw the SOP’s focus on assets and liabilities as
emphasising the balance sheet at the expense of the matching concept.
They saw this as meaning that certain items which presently appear in
the balance sheet as a result of the matching process (certain deferred
debits/credits) would be excluded. They agreed that accounting should
continue to be based on the recognition of transactions. The SOP retains
the emphasis on assets and liabilities, but points out that transactions will
continue to be the most common form of event affecting the elements and
therefore the most common reason for recognising and de-recognising
items in financial statements. However, it does not accord primacy to
matching; the matching process will be restricted in that expenditure and
losses will be carried forward only if there are economic benefits still to
be derived from them. Baxter, in supporting this approach, points out that
‘matching’ is a misnomer:
46
Chapter 2: Conceptual framework
Activity 2.5
How might a conceptual framework be used to counter lobbying by pressure groups
whenever a new (contentious) accounting standard is proposed?
Contrast the UK approach to standard-setting (often allowing choices of accounting
method) with the US approach (more detailed, specific).
Question 2.2
The FASB’s conceptual framework was expected to:
a. guide the body responsible for establishing standards
b. provide a frame of reference for resolving accounting questions in the
absence of a specific promulgated standard
c. determine bounds of judgement in preparing financial statements
d. increase users’ understanding of, and confidence in, financial
statements
e. enhance comparability.
How feasible do you think are all of these expectations? What difficulties
can you identify that the FASB might have in its attempt to satisfy all five
expectations?
Question 2.3
Evaluate efforts to date to re-orientate the conceptual framework for
financial reporting that are part of the IASB and FASB convergence project.
47
AC3091 Financial reporting
Notes
48
Chapter 3: Income measurement and capital maintenance
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• contrast the accountant’s and the economist’s approach to income and
asset value measurement
• explain Hicks’s definition of ‘well-offness’ and measures of income
numbers 1 and 2
• discuss ex ante income and both ex post incomes for Hicks’s income 1
and 2
• calculate income ex ante and ex post for both Hicks’s income measures
• discuss the implications of Hicks’s income measures for both
economists and accountants.
Essential reading
International Financial Reporting, Chapter 4.
Further reading
Beaver, W.H. and J.S. Demski ‘The Nature of Income Measurement’, Accounting
Review 54(1) 1979.
Bromwich, M. Financial Reporting, Information and Capital Markets. (London:
Pitman Publishing, 1992) [ISBN 9780273034643]. Chapters 3 and 4.
Hicks, J.R. Value and Capital. (Oxford: Clarendon, 1946) second edition.
Chapter 14.
Hicks, J.R. ‘Incomes’ in Parker, R.H., G.C. Harcourt and G. Whittington (eds)
Readings in the Concepts and Measurements of Income. (Oxford: Philip Allan,
1986) second edition [ISBN 9780860035367].
Lewis, R. and D. Pendrill Advanced Financial Accounting. (Harlow: Financial
Times Prentice Hall, 2004) seventh edition [ISBN 9780273658498].
Chapter 4.
Paish, F.W. ‘Capital and Income’, Economica 7(28) 1940.
Solomons, D. ‘Economic and Accounting Concepts of Income’, Accounting
Review 36(3) 1961 (reprinted in Parker, R.H., G.C. Harcourt and G.
Whittington (eds) Readings in the Concepts and Measurements of Income.
(Oxford: Philip Allan, 1986) second edition [ISBN 9780860035367]).
Whittington, G. Inflation Accounting: An Introduction to the Debate. (Cambridge:
Cambridge University Press, 1983) [ISBN 9780521270557]. Chapter 2.
49
AC3091 Financial reporting
Activity 3.1
Compare and contrast the views of income and capital discussed above.
Activity 3.2
A business is set up by Zillah Corporations with an expected four-year life. At the start of
2010, the cash flows expected to occur at the end of the years to which they relate are:
£
2010 10,000
2011 8,000
2012 6,000
2013 4,000
Assume the interest rate is 10% and is expected to remain constant.
What would be the economic value of the business at the start of 2010 (i.e. V2010)?
The solution to this activity is given in Appendix 1.
50
Chapter 3: Income measurement and capital maintenance
(Note that Hicks uses ‘week’ to denote a period during which variations
in price might be neglected in analysis; extreme inflatory conditions, for
example, may problematise this.)
Although Hicks’s analysis relates to the individual, it has also been applied
to measuring corporate income. The Sandilands Committee on inflation
accounting based its proposals on Hicks’s central concept, defined for a
company as:
the maximum value the company can distribute during the year
and still expect to be as well off at the end of the year as it was
at the beginning.
51
AC3091 Financial reporting
The capital values are measured excluding dividends, i.e. V1 does not
include the cash flow receivable at time 1 (D1). Income number 1 for the
period from time 0 to time 1 (Y0→1) is thus measured as:
Y0→1 = D1 + V1 – V0
If the individual actually consumes this amount of income (assuming
consumption in the period from t0 to t1 is all paid for at the time t1), then
remaining wealth at t1 is V0, so the individual is as well-off at the end of
the period as at the beginning. The above expression can be interpreted in
two ways. First, we can write the expression as:
Y0→1 = (D1 + V1) – V0
The term in parentheses represents the total expected wealth, made up of
net cash received plus the present value of expected future net receipts, at
the end of the first period. So Y0→1 is the amount by which total wealth is
expected to increase during the period.
The second way of splitting the expression above is:
Y0→1 = D1 + (V1 – V0)
This can be interpreted as dividing economic income into two components:
the expected cash flow for the period and the expected change in the value
of the individual’s wealth (excluding end-of-period cash D1). We might
refer to the component in parentheses as an expected holding gain or
loss. This should be distinguished from a windfall gain or loss (discussed
below), which is unexpected.
Example 1: perpetuity
A government bond pays £150 a year for ever. If the interest rate is 10%,
then the capital value of the bond at time 0 (ex interest) is:
£150 = £1,500 = V0
0.1
At t1 the value of the bond (cum, or with, interest) is:
£150 = £1,650 = V1
£150 +
0.1
Example 2: an annuity
An annuity pays £150 p.a. at the end of each of the three years and
costs £373.00. The interest rate is 10%. Analyse each year’s receipts into
‘income’ and repayment of ‘capital’. Assume that all the ‘income’ is spent
and the ‘capital’ receipts are reinvested in a bank account which pays
interest at 10%:
52
Chapter 3: Income measurement and capital maintenance
£ 1 2 3 4 5 6 7 8 9
Opening Income ‘Capital’ Total Interest Total Capital Bank Total
value from receipt receipts on bank income value of balance capital
annuity from from deposit (2+5) annuity (7+8)
(10%×1) annuity annuity @ 10% after
(10% × 8) payment
Time
t0 – – – – – – 373.00 – 373.00
t1 373.00 37.30 112.70 150.00 – 37.30 260.30 112.70 373.00
t2 260.30 26.03 123.97 150.00 11.27 37.30 136.33 236.67 373.00
t3 136.33 13.63 136.37 150.00 23.67 37.30 – 373.00 373.00
Thereafter the bank pays £37.30 interest each year on the balance of
£373.00.
Applying the formulae above, we find:
V0 = £373.00
V1 = £260.30
D1 = £150
Y0→1 = £150 + £260.30 – £373 = £37.30
Note: The actual financing and consumption policy adopted will not alter
the calculation of the income from the annuity in column 1.
Activity 3.3
If the cost of capital is 10%, what is the NPV of the project to the nearest £1?
The solution to this activity is given in Appendix 1.
Analyse the cash flows into ‘income’ and ‘capital’, on similar assumptions
to the previous example above and assuming the initial outlay of £4,000
was borrowed via a bank overdraft.
53
AC3091 Financial reporting
£ 1 2 3 4 5 6 7 8 9
Opening Income Capital Total Interest Total Capital Bank Total
value from receipt or project received/ income value of balance capital
project shortfall receipts (paid) to (2+5) project (overdraft) (7+8)
(10% × 1) (4 – 1) (payments) bank
(10% × 8)
Time
t0 – – (4,000) (4,000) – – 4,560 (4,000) 560
t1 4,560 456 1,544 2,000 (400) 56 3,016 (2,456) 560
t2 3,016 302 1,198 1,500 (246) 56 1,818 (1,258) 560
t3 1,818 182 1,818 2,000 (126) 56 – 560 560
Therefore the bank account will pay £56 p.a. interest on the £560 balance.
Applying the valuation and income formulae above:
Project value at time 1 = £1,500 × (0.9091) + £2,000 × (0.8264) = £3,016
Project value at time 2 = £2,000 × (0.9091) = £1,818
(
V0 =
£1,000
+
£2,000
×
1 (
= £909.09 + £18,181.82 = £19,090.91
1.1 0.1 1.1
(= PV of future cash flows from t0 onwards)
Therefore income number 1 equals £1909.09:
£1,000 + £20,000 – £19,090.91 = £1,909.09
How can he consume £1,909.09 when the year’s cash flow is only £1,000?
He only has cash of £1,000, but could borrow £909.09 from the bank at the
prevailing rate of interest; this would reduce his capital at time 1 (V1) from
£20,000 to £19,090.91 thus maintaining his original capital (V0).
Interest of £90.91 p.a. on the loan would reduce net future cash flows to
(£2,000 – £90.91) = £1909.09 p.a. (Rather than borrow, he could realise
£909.09 of the capital value at time 1 by sale, leaving capital value at
£19,090.91, on which future receipts at 10% p.a. would be £1,909.09.)
Future income will remain at £1909.09 p.a. provided he exactly maintains
his opening capital.
In this example income equals the rate of interest (r) applied to the opening
capital value (i.e. rV0). This is because V0 equals (D1 + V1) discounted back
one period by r, which in turns means that (D1 + V1) equals (1 + r)V0 ;
income may thus be expressed as (1 + r)V0 – V0, or rV0.
It should also be noted that, on the assumptions made so far, if the opening
capital is exactly maintained and all the income (including the accretion to
54
Chapter 3: Income measurement and capital maintenance
capital value) consumed, then in future years the income figure would be
constant (and equal to rV0).
Summary of formulae:
Y0→1 = D1 + V1 +V0
D1 + V1
V0 =
1+r
(1 + r)V0 = D1 + V1
Y0→1 = (1 + r)V0–V0
Y0→1 = rV0
Version A
Version A may be expressed as:
Income number 1 Y0→1 ex post version A = D1t1 + V1t1 – V0t0
This is actual cash flow for the period plus capital accumulated including
windfalls. Hicks describes income ex post as income ex ante plus windfalls.
Thus the definition of ex post income incorporates all windfalls measured
as:
(D1t1 + V1t1) – (D1t0 + V1t0)
Here, income is no longer equal to rV0t0 (because windfalls are not
reflected in the opening capital value).
It could be argued that the definition of Hicks’s income 1 ex post version
A set out above is meaningless as it compares two numbers calculated
using information available at time t1 with a number calculated using only
information available at time t0. If the individual had the information at t0
that the individual has at t1, the individual’s calculation of NPV would not
have been the originally calculated V0t0 but rather:
1
V0t1 = (D1t1 + V1t1)
1+r
This gives an alternative version of ex post income: version B.
Version B
Version B may be expressed as:
Income number 1 Y0→1ex post version B = D1t1 + V1t1 – V0t1
This is actual cash flow for the period, plus capital accumulation
excluding windfalls.
Windfalls are excluded because we have restated our opening capital with
the benefit of hindsight to what it would have been had we had perfect
foresight at t0. This measure would therefore have been our ex ante income
number 1 if we had had perfect knowledge at t0; it follows that income
under this version is equal to rV0t1.
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Chapter 3: Income measurement and capital maintenance
The treatment adopted for these ex post windfalls determines our ex ante
income for future periods (assuming we consume all income). Including
them in income under version A maintains our originally foreseen capital
value as the basis for measuring future income ex ante and (assuming
constant interest rates) our ex ante income for the next period would equal
ex ante income for this period (rV0t0). Excluding them from income as per
version B maintains revised opening capital value as the basis for future
ex ante income and (assuming constant interest rates) ex ante income for
the next period would equal ex post (version B) income for this period (=
rV0t1). Thus this second version of ex post income is closer to Hicks’s own
intentions than version A.
Example 5
A project is expected to generate cash flows of £10,000 p.a. in perpetuity.
The interest rate is expected to remain at 10% p.a. Cash flows arise at year
end. At the end of the first year the actual cash receipts are £5,000. At that
time, expectations of future cash receipts are changed to £12,000 p.a. The
interest rate for the first year is 10% and is expected to remain unchanged.
1. What is the income for the first period (i) ex ante and (ii) ex post?
2. Reconcile the ex ante income with both versions of ex post income.
At time 0 and time 1 we have the following information:
t0 t1 t2 t3 t4 →
8
Cash flows 10,000 10,000 10,000 10,000
D1 0 ………….… → V 1t0 →………
V 0t0 →……………………………………………………………………… →
t0 t1 t2 t3 t4 →
8
V 0t1→ ……………………………………………………………………… →
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AC3091 Financial reporting
Income 1 ex ante,
Y0→1 ex ante= D1t0 + V1t0 – V0t0
= £10,000 + £100,000 – £100,000 = £10,000
(= 10% × £100,000 = rV0t0)
Income 1 ex post,
Y0→1 ex post version A = D1t1 + V1t1 – V0t0
= £5,000 + £120,000 – £100,000
= £25,000
(no longer equal to interest on the opening capital value).
Y0→1 ex post version B = D1t1 + V1t1 – V0t1
= £5,000 + £120,000 – £113,636
= £11,364
(= 10% × £113,636 = rV0t1)
Note that even if ex post income is based upon knowledge of the actual
cash flow that we know at time 1, it is still based upon expectations of the
future from time 1 onwards; V1t1 still measures expected future cash flows
discounted at the expected rate of interest. Thus, income ex post is still a
very subjective measure.
Reconciliation £
1. Budgeted income for year (ex ante) £10,000
Revision of current cash flow (D0t1 – D1t0) <5,000>
Revision of forecast cash flows +2,000 £20,000
0.1
Income for the year (ex post) version A £25,000
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Chapter 3: Income measurement and capital maintenance
Ex ante variables
r 0t 0 = the interest rate from time 0 to time 1, given our knowledge and
expectations at time 0
r 1t 0 = the interest rate from time 1 to time 2, given our knowledge and
expectations at time 0
r nt 0 = the interest rate from time n to time n + 1, given our knowledge and
expectations at time 0
Ex post variables
r 0t 1 = the interest rate that actually prevailed from time 0 to time 1
r 1t 1 = the interest rate from time 1 to time 2, given our knowledge and
expectations at time 1
r nt 1 = the interest rate from time n to time n + 1, given our knowledge and
expectations at time 1
Example 6
A security pays £200 a year forever. At time 0 the interest rate is expected
to be 10% p.a. for the first two years and 20% p.a. thereafter. All cash
flows arise at year end. At the end of each year the difference between
income (calculated on a number 1 basis) and cash received is invested in a
bank account at the prevailing interest rate so as to maintain the opening
capital value. What is income number 1 ex ante for each of the first three
years?
Ex ante variables
D1t0 = £200 (= Dtn0 for all n from 2 to infinity)
£200
V2t0 = = £1,000 (Vnt0 for all n from 3 to infinity)
0.2
(
V1t0 =
£200
+
£200
×
1
(
= £1,090.91
1.1 0.2 1.1
(
V0t0 =
£200
+
£200
+
£200
×
1
= £1,173.55
(
1.1 (1.1) 2
0.2 (1.1)2
r0t0 = r1t0 = 10%
r2t0 = 20% = rnt0 for all n from 3 to infinity
Y0→1 = £200 + £1,090.91 – £1,173.55 = £117.36
(=10% × £1,173.55)
£82.64 will be invested in the bank, so that total capital at time 1 is now
£1,173.55 (i.e. the security valued at £1,090.91 plus the bank balance of
£82.64). The expected capital value at time 2 is now the security valued
at £1,000 plus £82.64 in the bank, a total of £1,082.64. The bank pays
interest of £8.27 (rounded) at t2 so that cash receipts at time 2 total
£208.26.
Y1→2 = £208.27 + £1,082.64 – £1,173.55 = £117.36
£90.91 will be invested in the bank at t2, so that total capital (security plus
bank balance) is once more maintained at £1,173.55; the total amount
now in the bank is £173.55 (i.e. £82.64 plus £90.91), on which interest at
20% will be £34.71 p.a. Future cash receipts will therefore total £234.71.
Capital value at time 3 will consist of the security valued at £1,000 and the
bank deposit of £173.55 = £1,173.55.
Y2→3 (and each year thereafter) = £234.71 + £1,173.55 –
£1,173.55 = £234.71
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AC3091 Financial reporting
When interest rates are not expected to change (and do not change), this
will be the same as income number 1; if interest rates are expected to
change (or do unexpectedly), the two income measures differ and Hicks
regards number 2 as a better measure of income and closer to his central
concept. In example 6 above, income number 2 would be £200 every year
– the amount the security pays every year regardless of the interest rate.
Note also the effect of an unexpected change in the interest rate on income
number 1, ex post, compared with income 2, even when cash flows are
regular perpetuities.
Example 7
A bond pays £100 at the end of each year forever. The rate of interest is
expected to be 20% p.a. forever (i.e. r0t0 = rnt0 for all n from 1 to infinity),
so the bond’s value is £500 (i.e. 100/0.2). At time 1 the interest rate (r1t1)
unexpectedly changes to 10% and is expected to remain at 10% forever
thereafter (i.e. r1t1 for all n from 2 to infinity); the bond’s value therefore
rises to £1,000 (i.e. 100/0.1). The revised opening capital value is:
(D1t1 + V1t1) 100 + (100/0.1)
V0t1 = = = £916.66
1.2 1.2
Income ex ante, both number 1 and 2, is £100 (= 20% × £500, i.e.
r0t0(V0t0)) since the interest rate is not expected to change.
Income number 1 ex post version A is: 100 + 1,000 – 500 = 600
Income number 1 ex post version B is: 100 + 1,000 – 916.66 = 183.34.
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Chapter 3: Income measurement and capital maintenance
Although this is 20% on the revised opening capital value (i.e. r0t1(V0t1))
note that future income ex ante will no longer be this amount, but
(assuming that all of the income is consumed so that the capital is
maintained at V0t1) will be 10% × £916.66 = £91.66 (i.e. r1t1(V0t1)).
But here income number 2 still measures ex post income as £100. The
constant annual cash flow is unaffected by the change in the interest
rate; it is therefore the amount that can be spent this period with the
expectation of being able to spend the same amount in all future periods.
(As noted below, however, if cash flows are not regular perpetuities, an
unexpected change in the rate of interest will affect income number 2 ex
post.)
Number 2 ex ante
When the net cash flows are regular perpetuities, income number 2 ex
ante will equal the amount of the net cash flows. If they are not regular
perpetuities but interest rates are assumed constant, it will (as noted
above) equal income number 1 ex ante. If the cash flows are not regular
perpetuities and there are expected changes in the interest rate, calculation
of income number 2 ex ante is more difficult. Assuming, however, that just
one change is expected, at time 1, after which rates are expected to remain
constant (i.e. r1t0 = rnt0 for all n from 2 to infinity), then income number 2
ex ante may be calculated by solving for Y in the following:
(
V0t0 =
Y
+
Y
×
1
(
1 + r0t0 r1t0 1 + r0t0
where Y equals the amount of the annual income. This reflects the fact
that the constant annual stream of consumption when discounted at the
prevailing interest rates must have a present value equal to the opening
‘well-offness’ or capital value. In the case considered here, it may be solved
also by finding income (Y) such that:
(V0t0)(r1t0)(1 + r0t0)
Y=
(1 + r1t0)
Number 2 ex post
Income number 2 will be affected if there are differences between
expected and actual cash flows or differences between originally expected
cash flows and our revised expectations of those cash flows. Once again
we will have ex post measures. Moreover, there will again be two different
measures of ex post income, depending upon how we treat windfalls.
Income number 2 ex post version A may be defined as:
the maximum amount an individual can consume in a period
and still expect to be able to consume the originally foreseen
number 2 ex ante income in all future periods.
This version treats as windfall gains or losses all end-of-year period wealth
that is not needed to generate in future periods the initially determined
Hicks’s number 2 income ex ante. The second version of ex post Hicks’s
number 2 aims to calculate the amount that, if consumed in the first
period, will leave enough wealth to permit the individual to consume the
same amount in all subsequent periods. Income number 2 ex post version
B may be defined as:
the maximum amount an individual can consume in a period and still
expect to be able to consume the same amount in all future periods.
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AC3091 Financial reporting
Example 8
A project is expected to generate cash flows of £2,000 per annum in
perpetuity. The rate of interest is expected to remain constant at 10%.
£2,000 is actually received at time 1, but at that time the rate of interest
suddenly changes to 20% and is expected to remain at that level forever.
Also at that time, expectations of future cash flows are changed to £4,000
per annum forever. All cash flows arise at the end of the year.
What is the income for the first period?
Ex ante Beginning of
the year
currently
here ↓
t0 t1 t2 t3 t4 →
8
Cash flows 2,000 2,000 2,000 2,000
r0t0 = 10%
(= rnt0 for all n from 1 to infinity)
r1t1 = 20%
(=rn t1 for all n from 2
to infinity)
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Chapter 3: Income measurement and capital maintenance
Reconciliation £
Budgeted income for year ex ante 2,000
+2,000
Change in forecasted cash flows + = 20,000
0.1
2,000 2,000
Change in interest rate – = <10,000>
0.2 0.1
Income for the year ex post version A 12,000
(
V0t1 =
Y
+
Y
×
1
(
1 + r0t1 r1t1 1 + r0t1
(
2,000 =
Y
+
Y
×
1
(
1.1 0.2 1.1
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AC3091 Financial reporting
Reconciliation £
Budgeted income for year ex ante 2,000.00
+2,000 1
Change in forecasted cash flows × = 8,333.33
0.2 1.2
Interest on revision capital @ 20% (8,333.33 × 0.2) = 1,666.67
Note that this is the only ex post income measure that involves no looking
backwards. The other figures are based on information at time t0 or use
the interest rate that has just passed. Hicks’s income number 2 ex post
version B uses only end-of-year realisations of cash flows and capital
values and prospective interest rates.
Hicks sees that the problem with calculating this lies in finding an
appropriate index number of prices – a problem we return to in our
discussions of current purchasing power accounting in Chapter 4.
66