ANSWERS TO PRACTICE QUESTIONS : SECTION 2 SECTION B-TYPE QUESTIONS : REPORTING STANDARDS 14 FINANCIAL PERFORMANCE (JUN 05 EXAM) Key answer tips This question tests the current issues topic of financial performance and the reasons for the proposed changes to the current rules. itis the sort of question that is very difficult to answer without the requisite knowledge. It is an important area so try and note some of the Examiner's key points from the answer. {a) The main reasons why the three accounting standards boards have decided to come together in a joint project regarding a single performance statement are as follows: 2 (i) There are many different formats and classifications used for financial statements and different time periods used for comparative data in different countries. : (ii) There are no common definitions as regards the key elements of financial performance and no agreement on the standard definitions of the key ratios which would then determine the nature of the information that financial statements should provide. There has been an increase in the reporting ofF alternative and often inconsistent financial performance measures that has led to confusion and often has misled users. < (ili) There has been an increase in the use of pro forma reporting which would tend to suggest that the existing totals and sub totals in financial statements are not, being used or relied upon as much as in the past. (iv) There are benefits in separating transactions and events that are recorded at historical cost from those recorded at fair value. Also, the differentiation between trading and holding gains gives useful information, This ‘mixed attribute’ model is causing concern over the effects on reported performance, (v) There is often insufficient disaggregation of data which prevents effective [ financial analysis of performance. (vi) There has been an inconsistency in the use of ‘recycling’ in financial statements of different jurisdictions which has led to issues of reporting gains and losses twice. (vil) The reporting of gains and losses on financial instruments required consideration. The gains and losses may currently be reported under several headings dependent upon the nature of the instrument. KAPLAN PUBLISHING 199PAPER P2 (INT AND UK) : CORPORATE REPORTING (b) (vill) There are many relevant items excluded from the performance statements and ix) (i) inappropriate items included. For example the reporting of foreign currency gains/losses on the retranslation of the net investment in foreign operations is normally recognised in equity in many countries and a proposed dividend shown on the face of the statement of comprehensive income when it does not meet the definition of a liability and is a transaction with the owners of the business and not third parties. Information is inconsistently classified within and outside totals and subtotals. Currently there are many rules on how gains and losses on property, plant and. equipment should be reported and these have traditionally varied from country to country. The main issues revolve around the reporting of depreciation, disposal/revaluation gains and losses, and impairment losses. The reporting of such elements should take into account whether the property, plant and equipment have been revalued or held at historical cost. The problem facing standard setters is where to report such gains and losses. ‘The question is whether they should be reported as part of operating activities, or as other gains and losses. Holding gains arising on the sale of property, plant and equipment could be reported separately from operating results so that the latter is not obscured by an asset realisation that reflects more a change in market prices than any increase in the operating activity of the entity. Other changes in the carrying. amounts of property, plant and equipment will be reported as part of the operating results. For example, the depreciation charge tries to reflect the consumption of the asset by the entity and as such is not a holding toss. There may be cases where the depreciation charge does not reflect the consumption of economic benefits. For example, the pattern and rate of depreciation could have been misjudged because the asset’s useful life has been assessed incorrectly. In this case, when an asset is sold any excess or shortfall of depreciation may need to be dealt with in the operating result. Impairment is another factor to consider in reporting gains and losses on property, plant and equipment. Impairment is effectively accelerated depreciation. impairment arises when the carrying amount of the asset is, above its recoverable amount. It follows therefore that any impairment loss should be reported as part of the operating result. Any losses on disposal, to the extent that they represent impairment, could therefore be reported as part of the operating results. Any losses which represent holding losses could be reported in other gains and losses. The difficulty will be differentiating between holding losses and impairment losses. There will have to be clear and concise definitions of these terms or it could lead to abuse by companies in thelr quest to maximise operating profits. A distinction should be made between gains and losses arising on property, plant and equipment as a result of revaluations and those arising on disposal. ‘The nature of the gain or loss is essentially the same although the timing and certainty of the gain/loss is different. Therefore revaluation gains/losses may be reported in the other gains and losses section, Where an asset has been revalued, any loss on disposal that represents an impairment would be charged to operating results and any remaining loss reported in other gains and losses. 200 KAPLAN PUBLISHINGCo) ANSWERS TO PRACTICE QUESTIONS ; SECTION 2 Essentially, gains and losses should be reported on the basis of the characteristics of the gains and losses themselves. Gains and losses with similar characteristics should be reported together thus helping the comparability of financial performance nationally and internationally. Recycling is an issue for both the current performance statements and the single statement. Recycling occurs where an item of financial performance is reported in more than one accounting period because the nature of the item has in some way changed. It raises the question as to whether gains and losses originally reported in one section of the statement should be reported in another section at a later date. An example would be gains/losses on the retranslation of the net investment in an overseas subsidiary, These gains could be reported annually on the retranslation of the subsidiary and then again when the subsidiary was sold. The main arguments for recycling to take place are as follows: ‘+ when unrealised items become realised they should be shown again * when uncertain measurements become certain they should be reported again + all items should be shown in operating or financing activities at some point in time as all items of performance are ultimately part of operating or financing activities of an entity. There is no conceptual justification for recycling. Once an item has been recognised in a statement of financial performance it should not be recognised again in @ future period in a different part of that statement, Once an item is recognised in the statement there is an assumption that it can be reliably measured and therefore it should be recognised in the appropriate section of the statement with no reason to show it again. Gains and losses should not be based on the notion of realisation. Realisation may have been a critical event historically but given the current financial exposures of many entities, such a principle has limited value. A realised gain reflects the same economic gain as an unrealised gain. Items should be classified in the performance statement on the basis of characteristics which are more useful than realisation. The effect of realisation is explained better in the statement of cash flows. Realisation means different things in different countries. In Europe and Asia It refers to the amount of distributable profits but in the USA it refers to capital maintenance, The amount of distributable profits is not an accounting but a legal issue, and therefore realisation should not be the overriding determinant of the reporting of gains and losses. ‘An alternative view could be that an unrealised gain is more subjective than a realised gain. In many countries, realised gains are recognised for distribution purposes because of their certainty because this gives more economic stability to the payment of dividends. ACCA marking scheme HH | Marks (a) Reasons 2 marks per point 8 (0) (Factors 2 marks per point 8 (i) Discussion ’ ‘Maximum /Available } KAPLAN PUBLISHING 204