Critique of the question (ACCA June 2014 q1b)
This is an excellent question on the theory of financial reporting and its purposes. It is designed to stimulate critical thought about the bases of measurement for financial reporting and to evaluate whether those bases are sound. For example, why is fair value necessary? Why do the financial statements not represent the proceeds that would be received from the sale of the business? Why is historical cost convention appropriate for published financial statements? How can a view presented by a combination of values based on different measurement models be true and fair?The thesis of the directors is based on a misconception about the nature of IFRS based financial reporting and one of the key objectives of the answer should address this misconception convincingly. The best way to convince the directors is to present a coherent explanation of the various measurement bases used in financial reporting of which fair values is only a part, and to show that far from letting users down financial statements based on IFRS are acceptable and useable to various users because they give a true and fair view.
This type of question is rare: the examiner does not normally examine accounting theory.The question is very challenging because it requires students to synthesise and evaluate concepts of financial reporting across various perspectives. It is expected that many students will struggle to answer this question because the higher order discursive skills expected to deal competently with the issues are frequently highlighted as inadequately developed and applied to similar challenges in the past.
Critique of the answer
The answer is disappointing because it fails to develop coherent arguments and explanations for the limited use of fair values in financial reporting. The case for fair values should have been made within the context of the measurement of comprehensive income for stewardship reporting which requires that all assets should be stated fairly, necessitating the use of fair values in some cases, where this is appropriate to the business model within which each asset is managed. Having not established a rationale for the choice of measurement concepts it is not surprising that the answer fails to justify the IASB’s “preference for a mixed system of measurements” and also fails to explain why “IFRSs do not require that all assets and liabilities are valued at fair value.” Instead, as the extract below shows, the writer resorts to unreasoned assertions that make standard setting and financial reporting practice seem arbitrary and incoherent.
Extract from ACCA June 2014 q1b paragraph 1
What are directors to make of“However, it is not a complete fair value system?” Won’t this confuse the directors even more? What does a complete fair value system look like?“Fair value” and “present value” are in the very weak opening statement:that theyare frequently used in IFRS does not address the directors’ misunderstanding of their effects on financial reporting amounts. Do they mean the same thing? How are they different? Not until the fifth sentence (after they have learnt about the uses and benefits of fair values) do directors get informed that IFRS 13 Fair Valueshad been developed and introduced to solve problems in the application of the concept of fair values.Given the directors’ misconception of the fair value concept this point should have been developed by explaining the problems that have been solved and the improvements that have been made as a result of the introduction of IFRS 13.
Extract from ACCA June 2014 q1b paragraphs 2,3,4
Verbatim knowledge shown in the above extract should not be used because it is the application of the knowledge that counts at the intellectual levels 2& 3. It is not clear how the above constitutes application, analysis, synthesis or evaluation. In other words it is not clear how the above clarifies or supports the following arguments that should have been made in answer to the directors’ concerns, that:
i)An eclectic approach, not fair value model alone, is at the heart of IFRSs
ii)IFRS Financial statements are not failing users
iii)IFRS Financial statements do not represent “financial values” of the business
iv)Fair values can be problematic as the financial crises of 2008/9 shows
As can be seen,without a binding argument the paragraphs standalone as if they belong to another text. In any case dwelling on such prescriptive content is needless elaboration and does not display higher order thinking: marks allocated for this are wasted marks because they don’t address the central issues.
Extract from ACCA June 2014 q1b
The above extract could have come out of a student’s notebook: at this level marks should not be allocated for regurgitating acquired knowledge. If the answer purports to represent the level of understanding and competence that candidates should have attained then it fails because: there is no evidence that the student has gained insights; there is no evidence of critical thinking and professional judgement. For example, the writer does not evaluate the significance of “derivatives” in financial reporting to warrant their special mention in such detail. The accumulation of technical details is more likely to confuse than illuminate the directors. “As regards derivative instruments…” is not an appropriate opening to a paragraph because derivatives are not specifically mentioned in the scenario by the directors. Their abrupt introduction,as with the general topic of financial instruments,is not indicative of coherent thinking. The purpose of the paragraph is not clear: which of the directors concerns is or are being addressed? For example, how does the above demonstrate that IFRSs are not letting users down? How do directors understand that amortised cost is an “appropriate” measure of value?
Extract from ACCA June 2014 q1b
The essay ends with an ambiguous statement22 that reads more like an introduction than a conclusion. Infact it is not meant to be a conclusion – it just happens to be the last sentence and it stands alone, unconnected to the rest of the essay. This is not satisfactory: an essay should have an introduction, a developed middle and a conclusion. This text does not have a structure: this is another indication of incoherent thinking that pervades the entire answer. But the sentence’s lack of structure is not the only fault it exhibits. More seriously,the sentence is ambiguous and this is not helpful to the directors. “… reported at market value only when it is acquired … and consolidated…” can either mean
i)market values of the acquired entity at each reporting date are used to consolidate the entity into the group; or
ii)market values of the entity at the acquisition date are used to consolidate the entity into the group.
In the context of addressing the directors’confusionand false expectations about the use and meaning of fair values this ambiguity is a serious deficiency of the answer.IFRS 3 Business combinations avoids this ambiguity by inserting the adjective “acquisition date” in front of “market values” making it clear that it is the acquisition date fair values that are used in consolidation. Why has the examiner not done this?
A suggested answer
IFRSs are designed for general purpose financial reporting and far from implementing a fair value model, the IASB applies an eclectic mix of measurement concepts, including fair values,to enable entities to measure performance in accordance with their individual business models. The directors’ expectation failure can be addressed by explaining how such an eclectic approach is basedon generally accepted accounting principles used for producing financial statements to give a true and fair view without necessarily reflecting the financial value of the business.
As IFRS based general purpose financial statements are primarily compiled for reporting to stakeholders about the stewardship of resources,historical financial information is predominantly used in measuring items,reflectingtheir fair values on the dates on which the related transactions take place.However, performance evaluation of the entity’s resources requires asset values to be stated fairly so that all the income that has accrued to the assets up to the reporting datecan be recognised while maintaining closing capital at an amount equal to the opening capital(plus contributions from equity participants during the reporting period).This comprehensive income measurement procedure also underpins the recognition of deferred tax to reflect the future tax effects of those transactions that are not realised in the current reporting period. Where the accrued income has been realised it is included in the profit or loss for the period; where it has not been realised it is included in the other comprehensive income of the period and presented in equitynet of applicable deferred tax.For general purpose financial statements the capital that is maintained is the money capital initially introduced by the equity participants and is not adjusted for changes in purchasing power. Such an adjustment would be necessary to maintain financial capital. But neither of these concepts represents financial value in the sense of a sale value for the business as a whole because capital maintenance is only concerned with maintaining initial capital and that does not imply reflecting its current market value if that is the effect directors envisage the application of IFRSs would achieve.
To present assets and liabilities fairly (which does not necessarily mean using fair values) requires their carrying amounts at the reporting date to be stated on the basis of individual circumstancesso as to reflect their substance in accordance with the fundamental concept of faithful representation. As general purpose financial statements are based on the going concern assumption the overriding principle in reflecting the substance of net assets is that assetsare presented at carrying values that can be recoveredfrom subsequent operations,and liabilities are presented at amountsrequired to settle or transfer the obligation. Impairment testing under IAS 36 Impairment of assets is an example of the application of the principle that the carrying values of assets should be stated at no less than theirsubsequent recoverable amounts.
The mode of recovery of the carrying values differs depending on how management intends to use the asset in the entity’s business model toextract economic benefits during the asset’s useful life. For example, IFRS 9 Financial Instruments measures financial assets at fair value and also at amortised cost,depending on the business model; IFRS 5 NCA held for sale and discontinued operationsmeasures NCA held for sale at fair value less cost to sell; IAS 2 Inventories measures inventories at the lower of cost and NRV and operating assets such as goodwill, PPE and intangible assets can be variously reported at historic cost, value in use (present value) or fair values less cost to sell,depending on the outcome of impairment testing in accordance with IAS 36 Impairment of assets.Therefore, the IASB in issuing IFRSs uses a mixed measurement model of carrying valuesderived froma variety of acceptable measurement bases.
The amounts resulting from the application of the mixed measurement model are presented in financial statements with adequate disclosures of accounting measurement policies and are acceptable to various users including auditors, analysts, investors, bankers, creditors and tax officials. Therefore IFRS are not letting users down: the measures of asset and liability values produced from such an eclectic approach are compatible with the objectives of general purpose financial statements and can give a true and fair view of the state of affairs of the entity at the reporting date and of the results for the period then ended. This approach minimises risksof material misstatements and uncertainty about carrying values and operational results, by using objective criteria to provide ample relevant information to usersthus fulfilling its limited potential for economic decision usefulness. For example, share price movements can be affected by the publication of IFRS based earnings figures and a substantial body of capital market research establishes a link between the publication of accounting earnings and investor behaviour.But this does not indicate that financial statements information represents valuation, although the information may be used as input to valuation models for equity pricing which might influence investor decisions to buy, hold or sell shares.
The above analysis shows that the directors’ “strong views” are misguided by the presumption that IFRS use fair value model to produce financial statements embodying financial values. It is not clear what “financial values” means nor does the context allow a specific interpretation of the term. A general interpretation is that financial value represents the amount that can be received to sell the business at the measurement date under IFRS 13 Fair valuesconditions.The above analysis indicates that fair values as defined under IFRS 13 Fair values only apply to certain components of financial statements of a going concern where they are deemed to be appropriate measures of carrying values. Even if all the components of financial statements are stated at fair values and aggregated, the resulting amount would not represent the financial value of the business because a business is not simply a collection of assets and liabilities. Such a collection of assets may qualify as a disposal group in which case,in accordance with IFRS 5 principles,it should be valued and included in the entity’s financial statements at fair value less cost to sell because the carrying value of the disposal group would be recovered through sale. A business valuation for sale would entail reflecting the fair values of goodwill and other intangibles and related liabilities not normally included in measurements for periodic general purpose reporting.
In conclusion the directors’ faulty expectationabout IFRSs and what IFRS based financial statements represent can be removed by accountants providing clear explanations of the nature of financial reporting under IFRS and the purposes it serves. As has been argued above given the presumption of stewardship reporting of a going concern entity the eclectic approach to measurement is coherent because it produces relevant information about the diverse modes of recovering the carrying values of a variety of assets held under different business models and of settling or transferring a variety of related liabilities. The directors’ implicit preference for fair values is a one-size fits all approach that does not necessarily achieve faithful representation of the market value of the business. Moreover, it can be argued that fair values did let users down during the financial crisis as mark-to-market(another name for fair values) had to be selectivelyreplaced by mark-to-model(an accounting pricing method that is based on a valuation model that reflects the business model in which the asset is used) after fair values were implicated as worsening the financial crisis because banks had to take huge losses after the markets for their assets suddenly disappeared and their fair values were as a result reduced to nothing.
ACCA P2 Q1c
Critique of this question
This is an excellent question set at the style and standard of a professional exam inviting candidates to deploy critical thinking in exploring how financial reporting principles apply to a complex transaction in a typical commercial context. The core challenge presented by the paucity of lease transaction detail is the divergent thinking required to rigorouslyexplore all the circumstances and options for classifying lease of land and buildings in assessing whether the FC or FD is right; to understand why they may both have been wrong; to pinpoint the potential ethical issue related to the FD’s preference and then to reason through the ethical principles and procedures towards a satisfactory resolution. This calls for maturity and demonstration of relationship management principles in conflict resolution.Typically, the examiner employs the duality technique which he has used to successfully test critical thinking and evaluative skills in relation to financial instruments classification (ACCA June 2014 q4Q&A), cash and cash equivalents (ACCA December 2013 q1bQA), financial instruments derivatives (ACCA June 2010 q3a QA)
Critique of this answer
Extract from the ACCA June 2014 answer to q1c
This answer fails to match the high quality of the question. Key weaknesses:
i)The answer fails to address at the outset the requirement of IAS 17 Leases to assess leases of land and buildings separately, to determine their individual classification as finance or operating lease. This weakness is serious because contrary to IAS 17 the rest of the answer presumes that the lease of land and buildings can be treated as a single unit as the FC and FD have done without evident justification. The possibilities are
-Single unit (finance or operating lease)
-Components (finance or operating)
Not reflecting these possibilities in the answer is a failure to adequately address the ethical and professional issues the FC faces, not least because faithful representation requires that all the circumstances of the transaction must be addressed in order to fairly reflect its substance in accounting terms.
ii)The whole of the first paragraph is verbatim knowledge without analysis and application. For example, having mentioned 1“substance” there is no application of the knowledge to context hence the answer is limited to Knowledge (Intellectual level 1) which is not appropriate at this professional level (assessed at level3: synthesis and evaluation). My feeling is that the approach adopted in this paragraph is wrong in that the scenario details do not allow this knowledge to be applied in a prescriptive way. An adequate answer isan exploratory approach to assess and resolve the ethical and professional issues from all perspectives relevant to the scenario. This would match the critical thinking and professional judgement being assessed.