4、(a) The existing Conceptual Framework has several notable omissions. It does not include an explicit reference to substance over form nor does it define derecognition or when derecognition should occur. The International Accounting Standards Board has also removed prudence from its framework and has attracted criticism from the academic and practitioner communities for doing so. However, the Exposure Draft on the Conceptual Framework attempts to explain the roles of prudence and substance over form in financial reporting whilst putting forward proposals to clarify the aims of the accounting requirements for derecognition.
Required:
(i) Discuss the features of the concept of prudence and the arguments for and against its re-introduction into the Conceptual Framework. (6 marks)
(ii) Explain why it is important for there to be guidance in the Conceptual Framework on the role of substance over form, and the principles relating to derecognition set out in the Exposure Draft on the Conceptual Framework. (8 marks)
(b) (i) Skye has B shares in issue which allow the holders to request redemption at specified dates and amounts. The legal charter of Skye states that the entity has a choice whether or not to accept the request for repayment of the B shares. There are no other conditions attached to the shares and Skye has never refused to redeem any of the shares up to the current year end of 31 May 2017. In all other respects the instruments have the characteristics of equity.
Skye also has preference shares in issue which are puttable by the holders at any time after 31 May 2017. Under the terms of the shares, Skye has to satisfy the obligation for the preference shares only if it has sufficient distributable reserves. Local legislation is quite restrictive in defining the profits available for distribution as dividends.
The directors of Skye wish advice on how to account for the above financial instruments in the company’s financial statements at 31 May 2017. (5 marks)
(ii) Skye faces a claim for infringement of the intellectual property rights of a competitor company. On 31 May 2017, Skye agreed to settle the claim and has paid $15 million to the competitor plus a variable amount of 2% based upon future sales. The variable amount represents compensation for the use of the intellectual property in the past (0·5%) and for its use in the future (1·5%). The directors of Skye have recently heard that the ED Conceptual Framework has changed the definition of a liability and now feel that there is no future liability arising on the settlement of the claim as it has paid the compensation due to date.
The directors of Skye, however, still require advice on the matter. (4 marks)
Required:
Advise the directors of Skye on how the above transactions should be dealt with in its financial statements with reference to relevant International Financial Reporting Standards.
Note: The mark allocation is shown against each of the three issues above.
Professional marks will be awarded in question 4 for clarity and quality of presentation. (2 marks)
(a) (i) The preparers of financial statements have to deal with the uncertainties which surround the preparation of financial statements. For example, events such as the collectability of doubtful receivables and the probable useful life of plant and equipment have a degree of uncertainty attached to them. Such uncertainties are recognised by the disclosure and by the exercise of prudence in the preparation of financial statements. Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated. However, the exercise of prudence does not allow for deliberate understatement or deliberate overstatement because the financial statements would not be neutral and, therefore, not have the quality of reliability.
Prudence is a term used by different people to mean different things. Some use it to refer to a need to be more cautious when making judgements relating to gains and assets than for those relating to losses and liabilities. Others feel that losses should be recognised at an earlier stage than gains. Faithful representation requires that financial statements are neutral and so an understanding of prudence is linked to an understanding of the term ‘neutrality’.
The arguments put forward against the reintroduction of prudence into the Conceptual Framework include the fact that there is no common understanding of what prudence means and thus there are different interpretations as to its meaning. This could lead to inconsistent application of the concept.
The exercise of prudence can lead to greater subjectivity in the financial statements, which will affect the evaluation of the entity’s performance.
However, the opposite view is that a reference to prudence should be reinstated in the Conceptual Framework. Certain Standards are underpinned by the concept of prudence and therefore it is important to explain prudence in the Conceptual Framework so that it can be applied consistently. Preparers of financial statements have a natural bias towards optimism and therefore prudence is needed to counteract this bias. Investors are often more concerned with the financial risk relating to potential losses. There are views that some form of conservatism has a role to play in financial reporting even though there are different views about what form this would take. Additionally, the financial crisis has demonstrated the need for prudence when making estimates.
(ii) The existing Conceptual Framework does not include an explicit reference to substance over form. However, accounting in accordance with an element’s legal form, and not its economic substance, would not result in a faithful representation. The Exposure Draft proposes that a faithful representation should provide information about the substance of an economic phenomenon instead of merely information about its legal form. Accounting for something in accordance with its legal form, even with appropriate disclosures, cannot result in a faithful representation if the economic substance of the item is different.
The existing Conceptual Framework does not define derecognition, nor does it describe when derecognition should occur. As a result, different standards have adopted different approaches to derecognition. The derecognition criteria need to reflect how best to portray both an entity’s rights and obligations and changes in those rights and obligations. The accounting requirements for derecognition should aim to represent faithfully the assets and the liabilities retained after the derecognition and the changes in the assets and the liabilities as a result of the transaction or event. If an entity disposes of an entire asset or an entire liability and retains no exposure to that asset or liability, then normally there is no issue, but it can be more difficult if an entity disposes of only part of an asset or a liability. In most cases, an entity will achieve the best result if it applies the control approach, that is by derecognising an asset or a liability when it no longer meets the recognition criteria.
(b) (i) IAS 32 Financial Instruments: Presentation states that a liability is a contractual obligation to deliver cash or another financial asset to another entity and that equity is any contract which evidences a residual interest in the assets of an entity after deducting all of its liabilities. In this case, Skye has no obligation to transfer cash or another asset to the holders of the instruments and therefore the B shares should be classed as equity. The fact that Skye has not refused redemption in the past does not cause the B shares to be classified as a liability.
The preference shares create an obligation for Skye because of the put option clause in the agreement. The fact that Skye may not be in a position to satisfy the put option feature because of insufficient distributable reserves does not negate the fact that Skye has an obligation.
(ii) The ED Conceptual Framework says that a liability is a present obligation of the entity to transfer an economic resource as a result of past events. A present obligation is an obligation to transfer economic resources which the entity has no practical ability to avoid and has arisen from a past event, that is, economic benefits already received or activities already conducted. The future sales-linked compensation is a mechanism for determining the amount of past and future use of the intellectual property. Therefore because part of the settlement is a variable amount to pay for past usage (even though this is based on future sales) Skye should recognise a financial liability under IFRS 9 at 31 May 2017. It is a present obligation as a result of a past event and this principle is the basis of the definition of a liability not only in the ED but also in the existing Conceptual Framework. As regards the sales-linked payment relating to future use, the liability arises as new sales are realised and represents an executory contract under IAS 37 Provisions, Contingent Liabilities and Contingent Assets. In these circumstances, Skye should not recognise a liability as the variable amount is based upon future sales, unless the executory contract is deemed to be onerous.