Dianne Azoor Hughes says there are five areas that the International Accounting Standards Board needs to consider when assessing submissions to its recent proposals.

    Professionals have questioned whether statutory financial reports can be more useful and meaningful to users. The Financial Reporting Council continues to monitor the reporting regime in Australia after issuing the FRC Managing Complexity Report in October 2012. However, the challenges to date are likely to fade into insignificance when compared to the challenges in the International Accounting Standards Board (IASB) proposals, as described in the discussion paper A Review of the Conceptual Framework for Financial Reporting. The comment period for submissions to the IASB closed on 14 January 2014. The due process that is now in play will be critical to the future of financial reporting and its usefulness.

    The IASB needs to give critical attention to five areas of primary concern.

    1. Is commercial reality cash?

    The IASB considers that commercial reality is best reflected through reporting economic value. Fair value measurement, the cornerstone of the International Financial Reporting Standards (IFRS), may be one view of commercial reality, but certainly not the only view.  Directors, management and investors are also interested in cash flow, particularly when going-concern or liquidity has been an issue. The reconciliation of operating profit to cash generated from operations becomes critical when faced with complexity in the numbers reported.

    The proposed definitions for assets and liabilities indicate that we may enter a reporting regime where assets and liabilities are represented by economic resources, capable of generating flows of economic benefits. In substance “capable of generating” means that those inflows or outflows of economic benefits need not be certain.

    Already, we can foresee the expectation gap expanding as investors try to identify actual cash flows, probable cash flows (as currently reported) and possible cash flows (in a future financial reporting paradigm).

    The subtle but careful use of language in the discussion paper warrants careful attention.

    “Existing and potential investors need information to help them assess the prospects for future net cash inflows to an entity…”

    Also needed is “information to help investors assess the amount, timing and uncertainty of future net cash inflows to the entity: in the statements of financial position, profit or loss and other comprehensive income (OCI), and cash flows, and in the notes…”

    There is no doubt that disclosure notes will provide comprehensive information to assist investor understanding, as long as they have an expert on standby to translate the technical jargon. Investors are likely to need expert advice to understand the uncertainties in the amounts reported and how they reconcile to actual cash movements. Financial statements will effectively provide prospective financial information about economic resources that an entity is capable of generating. Is this the primary information that investors require?

    2. The role of Economic Theory

    The economic principle providing the foundation for fair value accounting assumes investors make rational choices to optimise outcomes from their decision-making.  Market efficiency theory presumes market prices represent rational and correct prices. However, the market thrives on a different paradox; market participants trade on market inefficiency to identify opportunities to outperform the market.

    Similarly, under IFRS 13 “Fair Value Measurement”, fair value takes into account using an asset in its “highest and best use”. Do all market participants use assets in their highest and best use?

    What happens when companies are faced with going concern or liquidity problems as many were during the global financial crisis? What part does economic theory play in determining whether a business is sustainable, when managing cash flow is critical to its ongoing viability? Would investors prefer reliable (maybe conservative) cash flow forecasts or a statement of financial position that reports the net inflows (or outflows) or economic benefits that the business is capable of producing under assumptions and sensitivities explained somewhere in the pages of notes to the financial statements? Even the definition of purpose lacks clarity.

    3. Accounting for economic resources

    Currently, accounting records capture “transactions” that lead to the probable inflows or outflows of economic benefits. What kind of accounting records will be needed to capture “events” that indicate access to, or the need to transfer, an economic resource that is capable of generating flows of economic benefits?

    What kind of internal control environment will directors need to establish integrity in their financial reporting processes?

    4. Criteria for regulatory oversight 

    The IASB discussion paper explains that application of terms such as “reliable”, “probable” and “prudent” encourage conservatism in financial reporting. Therefore it proposes a broader understanding of “faithful representation” of elements in financial statements. Contemplate the likely dialogue when directors are asked by regulators to explain how they have selected the basis for the “faithful representation” of elements in their financial statements. Alternatively this may provide an ideal opportunity to bring in our colleagues in the legal profession to provide expert opinions to support a position taken. Will additional costs provide increased benefit?

    Directors, regulators, auditors, investors and other users may be challenged by their ability to distinguish between actual transactions generating actual cash flows and events generating economic resources capable of producing economic benefits. It may be difficult to distinguish the subtle but critical differences that could arise in measurement. There will be plenty of work for reporting experts to ensure that disclosure notes are appropriately crafted using technical terms and words that tell the financial story. The risk is that the story will have limited meaning to readers of the report.

    5. Business models

    The discussion paper refers briefly to how the business model concept is used in existing IFRS, but does not define the business model concept. 

    The IASB paradigm for financial reporting adopts a business model concept based on the ability to control returns, but ignores how choice of a business model can mitigate risk.

    The IASB ignores the commercial drivers for using contractual arrangements to secure economic benefits while limiting exposure to risk. 

    Consequently, the commercial drivers underlying the use of contracts to lease an asset or secure supply are not only ignored, but the risks that contracts seek to address are captured and reported in the financial statements in accordance with IFRS.

    What would financial reports look like if they were prepared under a business model concept that demonstrates how a business has utilised opportunities, mitigated risk and generated cash?

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