CHAPTER 3: Visual Overview

Objective: To set out the concepts underlying the preparation and presentation of financial
statements for external users.
1.1 Purpose and Status

1.1.1 Purpose

The purpose of the Conceptual Framework for Financial Reporting (“the Framework”) is:

 to assist the IASB to develop IFRS Standards based on consistent concepts;

 to assist preparers to develop consistent accounting policies when no Standard applies or
a Standard allows a choice;
 to assist all parties to understand and interpret the Standards.

The current version of the Framework used when developing and amending IFRS Standards was
issued in 2018.

As most IFRS Standards currently in issue were developed in line with earlier versions of the
Framework, their requirements do not always align exactly with the current Framework.

1.1.2 Status

The Framework is not a Standard. Nothing in it overrides any requirement in a Standard.

1.2 Objective of General Purpose Financial Reporting

General purpose financial reports provide financial information that is useful to existing and
potential investors, lenders and other creditors (the “primary users”) in making decisions
relating to providing resources to the entity.

Decisions depend on these primary users’ expectations about returns which depend on their
assessment of:

 the amount, timing and uncertainty of future net cash inflows; and
 management’s stewardship of economic resources.

Users therefore need information about:

 the entity’s economic resources (assets), claims against it (liabilities) and changes in
those resources and claims; and
 how efficiently and effectively the entity’s management and governing board have
discharged their responsibilities to use the entity’s economic resources.
1.3 Going Concern Assumption

Key Point
The going concern assumption underlies the preparation of financial statements.

 Going concern assumes that the entity will continue in operation for the foreseeable
future. This basis is presumed to apply unless users of financial statements are told
otherwise (in the notes to the financial statements).
 Therefore, there is neither the intention nor the need to enter liquidation or cease trading.
 If going concern is in doubt, a capital reconstruction may be necessary.

1.4 Elements of Financial Statements

Key Point
"Elements" of financial statements are broad classes of the financial effects of transactions
grouped according to their economic characteristics.
The Framework defines assets, liabilities and equity, and the definitions for income and expenses
follow on from those. Therefore, the Framework is said to take a "balance sheet approach".

Definitions
Asset – a present economic resource controlled by the entity as a result of past events.

Economic resource – a right that has the potential to produce economic benefits.
Key Point
An asset may exist where there is a low likelihood of economic benefits. However, this does not
mean it will be recognised. If it is recognised, the measurement of the asset will reflect this low
likelihood.
Definition
Liability – a present obligation of the entity to transfer an economic resource as a result of
past events.

There is no "probable criterion" for the transfer of economic resources:

 there must simply be the potential for a transfer;

 a low likelihood of transfer may affect the recognition and measurement of a liability.

Definitions
Equity – the residual interest in the assets of the entity after deducting all its liabilities.

Income – increases in assets or decreases of liabilities that result in increases in equity other
than those relating to contributions from holders of equity claims.

Expenses – decreases in assets or increases in liabilities that result in decreases in equity other
than those relating to distributions to holders of equity claims.

1.5 Recognition and Derecognition

1.5.1 Recognition
Definition
Recognition – the process of capturing for inclusion in the statement of financial position or
statement of financial performance an item that meets the definition of an element.

Recognition involves the depiction of the item in words and by a monetary amount and the
inclusion of that amount in one or more totals in that statement.

Only items that meet the definition of an element may be recognised. However not all items that
do meet these definitions are recognised.

Key Point
Inappropriate recognition can never be rectified by disclosure of the accounting policies used nor
by notes or explanatory material.

1.5.2 Recognition Criteria

An asset/liability is recognised only if recognising it (and any resulting income/expense or

changes in equity) provides information that is useful – i.e. it must be relevant and a faithful
representation.

Recognition may not always provide relevant information. For example:

 if it is uncertain whether an asset/liability exists (existence uncertainty); or

 it exists, but the probability of an inflow or outflow of economic benefits is low.

In order to be recognised, an item must be measured. Faithful representation requires

consideration of measurement uncertainty:

 Measurement uncertainty arises when monetary amounts in the financial statements must
be estimated (e.g. future cash flows).
 A high level of measurement uncertainty does not necessarily mean that recognition does
not result in useful information.
 In some cases a compromise solution is to use a slightly less relevant measurement basis
that is subject to lower measurement uncertainty.
 However, if measurement uncertainty is so high that no measurement basis would
provide useful information, an item should not be recognised. This is the case for most
internally generated intangible assets.

1.5.3 Derecognition

Derecognition is the removal of all (or part) of a recognised asset/liability from the statement of
financial position. It normally occurs when an item no longer meets the definition of an
asset/liability when the entity:

 loses control of an asset;

 no longer has a present obligation for a liability
1.6 Measurement Bases

1.6.1 Historical Cost vs Current Value

The Framework refers to two main measurement bases: historical cost and current value.

Historical cost is based on the transaction price when an asset was acquired/created or a liability
was incurred. This measurement basis does not generally reflect changes in values.

Current value does reflect changes in value. The Framework refers to three current value
measurements:

The price received to sell an asset or paid to transfer a liability (as defined in
Fair value
IFRS 13 Fair Value Measurement).
Value in use is the present value of cash flows expected to be derived from
Value in use/
the use of an asset and its ultimate disposal. Fulfilment value is the present
Fulfilment value
value of resources transferred to fulfil a liability
The cost of an equivalent asset/consideration that would be received for an
Current cost
equivalent liability, at the measurement date.

Although most IFRS Standards apply the historical cost measurement basis, some combine this
with other measurement bases (e.g. fair values for investment property and property, plant and
equipment).

1.6.2 Selection of a Measurement Basis

Management should refer to the fundamental qualitative characteristics of relevance and faithful
representation when selecting a measurement basis. Enhancing characteristics should also be
considered.

No single factor will determine which measurement basis should be selected; this will depend on
facts and circumstances. For example:

 Current values which reflect changes in value may be more relevant than historical cost,
particularly where an asset/liability is sensitive to market factors;
 Historical cost is verifiable; this is less likely for a current value measurement;
 Using a different measurement basis for assets or liabilities that are related to one another
can create measurement inconsistency which would compromise faithful representation;
 Where current values require the use of estimates, measurement uncertainty arises (i.e.
faithful representation may be questionable);
 The use of different measurement bases reduces comparability;
 Understandability is reduced where measurement bases are changed.
1.7 Presentation and Disclosure

1.7.1 As Communication Tools

The purpose of financial statements is to provide useful information to allow users to assess
financial position and performance and management stewardship.

Presentation and disclosure are communication tools and effective communication of

information in financial statements contributes to the qualitative characteristics.

Effective presentation and disclosure requires:

 A focus on presentation and disclosure objectives and principles: achieving a balance

between flexibility to provide relevant information that faithfully represents a transaction
and achieving comparability;
 Classification on the basis of shared characteristics: grouping similar items, separating
dissimilar items and, in general, not offsetting assets and liabilities;
 Aggregation of items that are included in the same classification: achieving a balance
between summarising a large volume of detail and concealing detail.

1.7.2 Profit and Other Comprehensive Income (OCI)

In principle:

 All income and expenses are included in the statement of profit or loss (rather than
recognised as OCI) unless an IFRS Standard requires otherwise; and
 All OCI is reclassified to profit or loss in a future period unless an IFRS Standard
requires otherwise

2.0 Attributes of Useful Information

Key Point
Qualitative characteristics of financial statements are the attributes that make information
provided therein useful to primary users:
Key Point

 Fundamental qualitative characteristics are:

o Relevance; and
o Faithful representation.
 Enhancing qualitative characteristics are:
o Comparability;
o Verifiability;
o Timeliness; and
o Understandability

3.2.1 Fundamental Characteristics

In order for information to be useful it must be relevant and present a faithful representation of
economic phenomena (i.e. assets, liabilities, transactions and events).

2.1.1 Relevance

Relevance concerns the decision-making needs of users. It helps users:

 to evaluate past, present or future events (i.e. has a predictive value); and
 to confirm or correct their past evaluations (i.e. has a confirmatory value).

Predictive and confirmatory values are interrelated (i.e. the same information may confirm a
previous prediction and be used for a future prediction).

Relevance of information is affected by materiality:

 information is material if its omission or misstatement could influence the decisions of

primary users taken on the basis of the financial statements;
 materiality is entity specific and based on nature (see Example 1) and/or magnitude;
 a uniform quantitative threshold for materiality cannot be specified because it depends on
an entity and particular circumstances.

Example 1 Nature of Information

During the year, Azure sold a property for $4 million. That is one piece of information. That it
sold it to another company which is owned by Azure's chief executive officer is additional
information.

$4 million may or may not be material in monetary terms. However, the nature of a related-party
transaction means that the additional information is relevant “by nature”.
The IASB has issued an IFRS Practice Statement Making Materiality Judgements (see next
chapter).

2.1.2 Faithful Representation

Useful information must represent faithfully that which it purports to represent (or could
reasonably be expected to represent).

To represent the economic phenomena faithfully may sometimes mean that the financial
statements do more than just follow accounting standards. A transaction which falls outside the
scope of all standards must still be reflected in the financial statements.

A faithful representation of information must be:

 Neutral (i.e. free from bias). This is supported by the exercise of prudence;
 Complete (within the bounds of materiality and cost) – an omission can cause
information to be false or misleading and therefore unreliable; and
 Free from error (i.e. no errors or omissions). This does not (it cannot) mean perfectly
accurate (e.g. due to the nature of accounting estimates).

Definition
Prudence – the exercise of caution when making estimates under conditions of uncertainty, such
that assets and income are not overstated and liabilities and expenses are not understated.

Prudence is evident in various requirements of existing IFRS Standards, for example:

 expected credit losses are recognised in respect of financial assets (IFRS 9);
 assets are tested for impairment and resulting losses are recognised (IAS 36);
 inventories are measured at the lower of cost and net realisable value (IAS 2);
 provisions are recognised for liabilities even if not certain (IAS 37).

Faithful representation also means presenting the substance of an economic phenomenon rather
than its legal form (see s.3)

3.2.2 Enhancing Characteristics

The enhancing qualitative characteristics improve the usefulness of financial information.

2.2.1 Comparability

Users need to be able to compare financial statements of:

 an entity through time – to identify trends in financial position and performance;

 different entities – to evaluate relative financial position, performance and changes in
financial position.

Comparability requires consistent measurement and display of the financial effect of like
transactions and other events.

An implication of this is that users must be informed of the accounting policies employed, any
changes in those policies and the effects of such changes. This is an explicit requirement of IFRS
Standards (see IAS 8 in Chapter 5).

Financial statements must show corresponding information for preceding periods.

2.2.2 Verifiability

Verifiability means that knowledgeable, independent observers could reach a consensus that a
particular representation has the fundamental quality of faithfulness.

Verification may be:

 direct (e.g. through physical inspection); or

 indirect (e.g. using a model, formula or technique).

2.2.3 Timeliness

Information needs to be available in time for users to make decisions. Older information is
generally less useful (but may still be useful in identifying and assessing trends).

2.2.4 Understandability

Users are assumed to have a reasonable knowledge of business and economic activities and
accounting, and a willingness to study information with reasonable diligence (i.e. they are
expected to have a level of financial expertise).

Information about complex matters should not be excluded on the grounds that it may be too
difficult for certain users to understand. Classifying, characterising and presenting information
clearly and concisely contributes to understandability

3.2.3 Cost Constraint

The cost of providing information should not exceed the benefit obtained from it:

 This cost, though initially borne by the reporting entity, is ultimately borne by the users
(e.g. through lower returns on their investment);
 Users also incur costs (e.g. in analysing and interpreting information).

Benefits are the most difficult to quantify and assess:

 the better the quality of information, the better decision making should be; and
 confidence in the efficiency of capital markets lowers the cost of capital.

3.3.1 Introduction

Key Point
Financial information must faithfully represent the substance of the phenomena that it purports to
represent.

Ultimately, financial statements should follow the Framework with respect to the definition of
elements and the recognition of assets and liabilities.

Usually, substance (i.e. commercial effect) and legal form are the same. For more complex
transactions, this may not be the case

3.2 Recognition of Assets and Liabilities

The key issue underlying the treatment of a transaction is whether an asset/liability should be
recognised in the statement of financial position.

Over the years, increasingly sophisticated "off balance sheet financing" schemes have been
devised to exclude assets and liabilities from the statement of financial position. This is one of
the most important issues in financial reporting. Some countries have issued accounting
standards to address this point specifically.

The concept of substance over form has existed as a concept in IFRS Standards for many years.
If companies had followed IFRS Standards, some of the reporting problems which have occurred
may not have arisen.
3.3.3 Creative Accounting

Over the past 40 years companies have tried to be creative in the way they account for certain
transactions. This has led to abuses of the accounting entries recording these transactions and the
financial statements not reflecting the economic reality of the situation. Listed here are some of
the main areas in which management have been creative in their accounting treatment.

3.3.1 Off Balance Sheet Financing

Finance is described as “off balance sheet” when a company has a present obligation to make a
payment but has been able to keep the obligation (debt) off the statement of financial position.
For example, if a sale and repurchase transaction is accounted for according to its legal form
rather than its substance. (This accounting treatment is contrary to IFRS 15.)

3.3.2 Profit Manipulation or Smoothing

Management prefer profits to increase at a steady rate and not fluctuate up and down each year in
an uncontrolled manner. Managers may therefore change how revenue and/or costs are
recognised in order to “smooth” profits. Examples of abuses in this area include early
recognition of revenue and incorrect recognition of provisions. These problems have been
addressed by IFRS 15 and IAS 37, respectively.

Example 2 Profit Manipulation

"Hollywood accounting" is a form of profit manipulation technique used in the film industry.
Many actors and screenwriters have contracts entitling them to a share of the profits of a film;
many studios ensure the film makes a loss by allocating overheads against the film even though
there may be no relationship between the film and the overhead. The film Forrest Gump is an
example of this form of profit manipulation. The film made millions in the box office, but when
the accountants got hold of the finances, they managed to turn it into a loss-making film,
depriving the author of his share of any profits from the film.

3.3.3 Window Dressing

The term “window dressing” is used to describe when the financial statements are made "pretty"
for one moment in time, normally the year end. Many ratios are calculated using figures from the
statement of financial position; if these figures can be made to look good, it will improve the
related ratios and put the company in a much better light.

Settling trade payables on the last day of the year, only to reinstate them the very next day, is an
example of this abuse.

Example 3 Window Dressing

"Repo 105" is a good example of window dressing. Lehman Brothers held some quite risky assets
in its statement of financial position, but entered into a contract to sell these assets towards the
 Example 3 Window Dressing
end of the financial year only to buy them back at the beginning of the following period.
Although not illegal, the ethics of a transaction of this nature must be called into question, despite
the fact that the company's auditors did allow the practice

Rate Your Confidence

Category
3.3 Substance Over Form

3.4 Accounting Theory vs Practice

The IASB produces accounting standards that prescribe the principles to be observed when
accounting for transactions (unlike US GAAP, which prescribes a set of accounting rules).
Principles require the exercise of judgment by users; one user may apply a stated principle in one
particular way, while another may apply the principle in a totally different manner. Fair value, as
an example, is a concept. What is fair value to one party may not be fair value to another party,
leading to different valuations for the same item.

However, even when a principle is applied in the same manner by two reporting entities, an
accounting standard may give a choice regarding measurement basis. For example, IAS 16
allows subsequent measurement of non-current assets using a cost model or revaluation model.
Identical items may therefore be measured at different carrying amounts by different reporting
entities.

Management will, in many cases, be looking to report the "best" profit figure possible. A "best"
profit figure may be the highest possible, a required profit or even a lower profit (e.g. to reduce
taxation).

Transactions and events may therefore be interpreted in the manner that shows the entity in this
"best" light, even if this is contrary to accounting theory. For example:

 Hotel chains have been averse to charging depreciation on hotel properties. Management
has argued that to do so would be to "double charge" profits due to the high levels of
maintenance expense incurred and that the recoverable amount of the hotel would exceed
its carrying amount if depreciation were recorded also.
 WorldCom classified revenue expenditure as capital expenditure, and so capitalised costs
that should have been charged to the statement of profit or loss.
 Enron excluded special purpose entities from its consolidated statement of financial
position. To have included them would have shown a much higher level of debt, one that
could not be sustained.
Accounting theory cannot capture all situations that can affect an entity's results. Accounting
standards do not cover every eventuality. For example:

 How should a Van Gogh painting be accounted for?

 What if it is held as an investment by a commercial entity?
 What if it is held by a not-for-profit entity for its contribution to culture (i.e. as a
“heritage asset”)?

Accounting theory does not currently address many events and transactions relating to the
Digital Age, for example accounting for cryptocurrencies.

Seasonal trends will also play a large part in how companies apply these principles. Holiday
firms, historically, have been geared to selling summer holidays in the early part of the year.
Should the revenue be recognised in the January/February period, or when the client actually
takes the holiday in the summer months?

Nearly every figure relating to assets and liabilities appearing in the statement of financial
position is subjective in its amount. Even the cash figure could be subjective; if a company has
foreign cash deposits, it must translate those back into its functional currency. What exchange
rate does it use?

So although the accounting theory may want a transaction to be accounted for in a particular
manner, the practice may not always follow that theory.

4.1 Bases

When an entity buys an asset, at that one point in time, there is really only one value that is
relevant – the amount that was paid for the asset (assuming it to be an economic transaction).

But suppose three years pass – what would be the most relevant and reliable value of that asset?

 Historical cost: the amount originally paid.

 Depreciated historical cost: having allocated some of its original cost over the period of
the asset's use.
 Replacement cost: how much would it cost to replace that asset, either in its original form
or based on the current value of a three-year-old asset.
 Net realisable value: the amount it could be sold for today, net of selling costs.
 Value in use: the present value of the future cash flows associated with using the asset.
 Fair value: the amount it could be sold for today before taking account of transaction
costs.

In conclusion, there is no one correct answer as it depends on the circumstances.

4.2 IASB Stance

As previously mentioned, the Framework identifies a number of measurement bases – historical

cost and current value (including fair value, value in use/fulfilment value and current cost).
Example 4 highlights the application of multi-measurement bases.

Example 4 Measurement Bases

Measurement bases that may be used for assets and liabilities included in the statement of
financial position include the following:

 Historical cost
o Land
o Inventory
 Depreciated historical cost
o Buildings
o Investment property
o Plant and machinery
o Patents
 Revalued amount
o Land and buildings
 Fair value
o Financial assets and liabilities
o Investment property
 Amortised cost
o Financial assets and liabilities
 Net realisable value
o Inventory
 Value in use
o Impaired assets
 Present value
o Decommissioning costs
 Equity accounting
o Investment in associate or joint venture

The above list is not exhaustive.

The IASB issued IFRS 13 Fair Value Measurement to address the measurement issues arising
when another standard requires the use of fair value (see next section).
There has been much debate over the past 40 years about the measurement of assets and
liabilities in the statement of financial position. For example:

 In the 1970s, a voluntary accounting standard was issued in the UK for applying constant
purchasing power (CPP) accounting. This was quite quickly withdrawn.
 In 1980, a new standard was issued in the UK that required listed companies to present
current cost accounts (CCA) in addition to historical cost accounting.
 However, widespread non-compliance led to it being made non-mandatory in 1986, and
in 1988 it was withdrawn.

At the extremes, measurement bases can be simple but not relevant to users (e.g. historical cost),
or complex but not easily understood by users (e.g. fair value). What is important is that the
financial statements reflect the economic phenomena relating to the events and transactions that
have occurred in the period. The measurement bases used must faithfully represent the events,
and the carrying amounts of assets and liabilities must be reliable and relevant to users.

 For the information relating to measurement bases used to be relevant and achieve
faithful representation, an entity must make numerous disclosures about how the bases
have been applied and how the carrying amounts have been derived.
 Judgments and assumptions (and other major sources of estimation uncertainty) that have
the most significant effect on the amount recognised must be disclosed (IAS 1).

The measurement bases selected will have a major impact on how users evaluate the financial
statements:

 If fair values are used then it is highly likely that profits will be far more volatile.
 If assets are revalued, return on capital employed will be lower than if a cost model was
used (assuming values are rising). Gearing will also be lower.

3.5.1 Terminology

Definitions
Fair value (IFRS 13) – the price which would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date.
Key Points
IFRS 13 does not prescribe when an entity should use fair value but how fair value should be
used. (For example, IAS 40 allows fair value measurement of investment property but IFRS 13
Key Points
specifies how that is measured.)

The definition of fair value is based on an exit price (taking the asset/liability out of the entity)
rather than an entry price (bringing the asset/liability into the entity).

 When measuring fair value, all characteristics of the asset/liability that a market
participant would take into account should be reflected in the valuation. This could
include the condition or location of the asset and any restrictions on the use of the asset.
 The definition is market-based and is not entity-specific. It reflects the use market
participants would use the asset/liability for, not what a specific entity would use the
asset/liability for.
 Not all standards use the IFRS 13 definition of fair value; for example, IFRS 2 Share-
Based Payment defines fair value as "the amount for which an asset could be exchanged,
a liability settled, or an equity instrument granted could be exchanged, between
knowledgeable, willing parties in an arm's length transaction".
 When IFRS 13 was issued, its scope excluded share-based transactions. The IASB felt
that a market-based value would over-complicate IFRS 2 and therefore retained the
existing definition.

Definitions
Active market – a market in which transactions for the asset/liability take place with sufficient
frequency and volume to provide pricing information on an ongoing basis.

Highest and best use – the use of a non-financial asset by market participants which would
maximise the value of the asset or the group of assets and liabilities within which the asset would
be used.

Principal market – the market with the greatest volume and level of activity for the
asset/liability.

Most advantageous market – the market that maximises the amount that would be received to
sell the asset or minimises the amount that would be paid to transfer the liability, after taking
transaction and transport costs into account

3.5.2 Price

Fair value is an exit price rather than an entry price. It is the amount that would be received for
an asset or paid for a liability in the principal market (or most advantageous market where there
is no principal market).
  Fair value can be a price that is directly observable or a price that is estimated using a
valuation technique.
 Fair value includes transport costs, but does not include transaction costs.
 Fair value is not adjusted for transaction costs as these costs are not characteristics of the
specific asset/liability. Any transaction costs are treated in accordance with other
standards and are generally expensed as incurred.

Key Point
Transaction costs must be ignored when measuring fair value because they are a cost of entering
into the transaction rather than a cost specific to the item being measured.

Transport costs are reflected in the fair value of an asset/liability because they change the
characteristics of the item (i.e. the location of the asset/liability is changed).

Example 5 Principal and Most Advantageous Markets

Jammee has business in two markets, Europe and Asia. Jammee has to place a fair value on an
asset it holds for accounting purposes. The market price of the asset in the two markets is $120
and $125, respectively.

Details relating to the asset in the two markets are as follows:

Europe Asia
$ $
Market price 120 125
Transaction costs (5) (11)
Transport costs (5) (2)
110 112
If Europe were deemed to be the principal market for the asset (because this is where the highest
volume of transactions took place), fair value would be $115 (price – transport cost).

If neither Europe or Asia were the principal markets for this asset, Jammee would use the most
advantageous market to determine fair value. This would reflect the best price available to sell the
asset after deducting transaction and transport costs.

In this situation Asia is the most advantageous market giving net proceeds of $112 vs $110 in
Europe. However, $112 is not the fair value of the asset. The fair value is $123, the price less
transport costs.

If the item were a liability then the most advantageous market would be Europe and the fair value
of the liability would be $115. This reflects the amount the entity would have to pay to settle the
liability, which is obviously better than having to settle at $123.

3.5.3 Highest and Best Use

For non-financial assets (e.g. investment property), fair value measurement must reflect the
highest and best use of that asset. This takes into account the use of the asset that is:

 physically possible;
 legally allowed; and
 financially feasible.

Taking account of the highest and best use may require assumptions that the asset will be
combined with other assets (i.e. in a group of assets) or with other assets and liabilities (i.e. in a
business) available to market participants.

Key Point
Current use of a non-financial asset is presumed to be its highest and best use unless market or
other factors suggest that a different use by market participants would maximise the value of the
asset

3.5.4 Valuation Techniques

The objective of the standard is to estimate the price at which the asset/liability could exit the
entity in an orderly transaction. Three common valuation techniques that may give an accurate
estimate are considered.

5.4.1 Market Approach

The market approach uses prices and other information generated in a marketplace that involve
identical or comparable assets/liabilities.

5.4.2 Cost Approach

A cost approach reflects the amount that would be required to replace the service capacity of the
asset (e.g. current replacement cost).

5.4.3 Income Approach

An income approach considers future cash flows and discounts those cash flows to a current
value. Models that follow an income approach include:

 present value; and

 option pricing models (e.g. Black-Scholes-Merton).
Exam advice
Option pricing is not examinable in SBR

3.

5.5 Hierarchy of Inputs

Valuation techniques require the use of inputs. For example an income approach requires the use
of estimated cash flows and interest rates. These inputs are categorised as level 1, 2 or 3 inputs.

5.5.1 Level 1 Inputs

Level 1 inputs are quoted prices in active markets for identical assets/liabilities that the entity can
access at the measurement date.

5.5.2 Level 2 Inputs

Level 2 inputs are inputs other than quoted prices that are observable for the asset/liability, either
directly or indirectly.

These would include prices for similar, but not identical, assets/liabilities that were then adjusted
to reflect the factors specific to the measured asset/liability.

5.5.3 Level 3 Inputs

Level 3 inputs are unobservable inputs for the asset/liability. The use of Level 3 inputs should be
kept to a minimum.

Key Point
The techniques used to estimate fair values should maximise observable inputs wherever
possible. The hierarchy (order) of inputs aims to increase consistency of usage and comparability
in the measurement of fair values and their related disclosures.

Activity 1 Investment Property

Exeter has an investment property with a floor area of 420 square metres. Exeter has adopted a
fair value policy for its investment property.

Similar properties in the same locality have been sold at prices which amount to $1,250, $1,255,
$1,260, $1,270 and $1,290 per square metre during the past month.
Required:

1. Calculate a fair value for the property using:

1. a mid-value; and
2. an average.
2. Suggest alternative fair values to those calculated in (a). Calculations are not
required.

*Please use the notes feature in the toolbar to help formulate your answer

3.5.6 Benefits and Limitations

5.6.1 Benefits

 Fair values provide information about the values of assets and liabilities that is most
relevant to current economic conditions. They therefore provide users with the most
"accurate" information available to help them make economic decisions.
 Certain other aspects of accounting are generally not required. For example, there should
be no need to test for impairment assets that are carried at fair value.
 Fair values provide a means for reliably measuring assets and liabilities that would not
otherwise be recognised (e.g. derivatives and other assets that have negligible/no initial
cost). This means that financial statements are more transparent.

5.6.2 Limitations

 The definition of fair values is market-based but market values may not be available for
many assets and liabilities. This gives rise to inconsistency in accounting treatment of
similar assets which renders financial statements less comparable. For example, most
entities have more than one class of tangible asset but typically only revalue property.
Intangible assets can only be revalued if there is an active market on which to trade them.
 Management may need to make significant judgments about the future to measure certain
fair values and some fair values are based on theoretical models. These values are less
reliable because they are more subjective and subject to the limitations of the models
used. The impact on the financial statements of hypothetical fair value that may never be
realised may mislead users.
 Users may not comprehend the significance of how changes in fair value affect reported
performance. In particular, the extent to which unrealised gains are reported in profit.
 One aspect of relevance is that information should assist users in predicting future events
and confirming past evaluations. That is, the users should be able to make predictions –
not the financial statements. Increasing the use of fair values may lead users to place
 more reliance on the financial statements as a prediction of the future than the auditor can
reasonably assure

Syllabus Coverage

Congratulations, you have covered the following Learning Outcomes:

B. The Financial Reporting Framework

1. The applications, strengths and weaknesses of an accounting framework

1. Discuss the importance of the Conceptual Framework for Financial Reporting in

underpinning the production of accounting standards.
2. Discuss the objectives of financial reporting including disclosure of information that can
be used to help assess management's stewardship of the entity's resources and the
limitations of financial reporting.
3. Discuss the nature of the qualitative characteristics of useful financial information.
4. Explain the roles of prudence and substance over form in financial reporting.
5. Discuss the high level measurement uncertainty that can make financial information less
relevant.
6. Evaluate the decisions made by management on recognition, derecognition and
measurement.
7. Critically discuss and apply the definitions of the elements of financial statements and the
reporting of items in the statement of profit or loss and other comprehensive income.

C. Reporting the Financial Performance of a Range of Entities

9. Fair value measurement

1. Discuss and apply the definitions of "fair value" measurement and "active market".
2. Discuss and apply the "fair value hierarchy".
3. Discuss and apply the principles of highest and best use, most advantageous and principal
market.
4. Explain the circumstances where an entity may use a valuation technique

Summary and Quiz

 The purpose of the Framework is primarily to assist the IASB in developing IFRS
Standards that are based on consistent concepts.
 The Framework states one underlying assumption: going concern.
 Recognition means including in the financial statements items that meet the definition of
an element and satisfy the recognition criteria.
 Qualitative characteristics are attributes that make information useful to primary users.
 Fundamental characteristics are relevance and faithful representation.
 Financial statements must reflect the economic substance of transactions if they are to
show a true and fair view.
 IFRS 13 does not prescribe when an entity should use fair value but how fair value
should be measured.
 Fair value is based on an exit price (rather than an entry price).
 Techniques used to estimate fair values should maximise observable inputs