Lecture 1
Monday, November 15, 2021
5:14 PM
Professional judgement in accounting
Accounting is not merely following a set of accounting rules or procedures — accountants are often called upon to
exercise professional judgement.
For example, the accountant may need to exercise professional judgement in deciding how to account for a transaction
that is not covered by a specific accounting standard.
Accountants may need to exercise professional judgement in deciding how to measure an asset or a liability where the
relevant accounting standard permits choice, or in the estimation of expected inflows or outflows used in the
measurement of assets and liabilities.
For example, in measuring a provision for warranty, the accountant must estimate the cost of settling the obligation at
the end of the reporting period.
Accounting policy
Accounting for routine transactions is typically straightforward. Entities develop policies for transactions that are routine
for their operations. Accounting policy decisions may also need to be made for one-off transactions or events.
Whether we are accounting for a one-off transaction or developing a policy for routine transactions, the accounting
policy decision involves four components, as follows.
 Definition.
o Did a past event give rise to an item that meets the definition of a financial statement element?
 Recognition.
o When does the item satisfy the recognition criteria?
 Measurement.
o How should it be measured initially and, in the case of an asset or a liability, how should it be measured
subsequent to initial measurement?
 Disclosure.
o How should the information be presented and disclosed?
Rules based vs principles based standards
Rules based standards
A rules-based standard attempts to prescribe the accounting treatment for every possibility, leaving little room for
judgement or discretion in its application.
Rules-based accounting standards use objective criteria in determining which accounting treatment should be applied to
a transaction, such as whether an item of expenditure should be accounted for as an asset or an expense.
For example, a rules-based standard might state that all expenditure on advertising, internally generated brand names
and internally generated mastheads must be accounted for as an expense. This leaves little scope for professional
judgement.
Advantages
Disadvantages



Easier to prepare financial
statements
More comparable
Specific rules - compliance is
easier
 Less interpretation
and subjectivity
 Less opportunistic
behaviour




Can be complex
Entities can structure transactions to circumvent
unfavourable reporting
Standards are likely incomplete or obsolete once
issued
Manipulated compliance with rules makes auditing
more difficult
Principles based standards
In contrast, a principles-based standard prescribes principles that can be applied to a range of different situations. The
application of the standard involves subjective assessment in applying the principles to various circumstances.
For example, let us assume that a principles-based standard specifies that a purchased intangible asset should be
recognised if it meets all of the following conditions.
 The entity has control over the intangible asset as a result of a past transaction or event.
 The intangible asset is expected to generate future economic benefits for the entity.
 It is probable that the future economic benefits will flow to the entity.
 The intangible asset has a cost that can be measured reliably.
In applying this principles-based standard to the acquisition of a patent, the accountant would need to exercise
judgement, particularly in assessing the probability that the patent will generate future economic benefits.
Advantages
Disadvantages





Principles-based standards
are simpler.
They supply broad guidelines
that can be applied to many
situations.
They improve the
representational faithfulness
of financial statements.
They allow accountants to
use their professional
judgement.
Evidence suggests that
managers are less likely to
attempt earnings
management.


Managers may select treatments that do not reflect
the underlying economic substance.
The judgement and choice involved in many of the
decisions mean that comparability among financial
statements may be reduced.
Key sources of regulation of financial reporting in Australia
The major sources of regulation of financial reporting in Australia are:
 the Corporations Act 2001
 Australian accounting standards
 the Conceptual Framework for Financial Reporting (Conceptual Framework)
 the Australian Securities Exchange Listing Rules.
The roles of key players in financial reporting regulation
Financial Reporting Council (FRC)
The Financial Reporting Council (FRC) is a statutory body under the Australian Securities and Investments Commission
Act 2001 (the ASIC Act 2001), as amended by the Corporate Law Economic Reform Program (Audit Reform and
Corporate Disclosure) Act 2004.
The FRC has responsibility for overseeing the effectiveness of the financial reporting system in Australia and is thereby
the key external adviser to the Australian government on the financial reporting system.
It provides broad oversight of the processes for setting accounting and auditing standards. It also provides strategic
advice on the quality of audits conducted by Australian auditors and advises the Minister on these and related matters
to the extent that they affect the financial reporting system in Australia.
Sections 225(5) and 225(6) impose explicit limits on the power of the FRC:
(5) The FRC does not have power to direct the AASB in relation to the development, or making, of a particular standard.
(6) The FRC does not have power to veto a standard made, formulated or recommended by the AASB.
Australian Accounting Standards Board (AASB)
The AASB is an Australian government agency under the ASIC Act 2001. The FRC appoints the members of the AASB,
except the chair, who is appointed by the treasurer of the Australian government. The AASB has the authority delegated
by the Federal Parliament to issue Australian accounting standards.
The functions of the AASB are specified in s. 227(1) of the ASIC Act 2001 as follows:
a. to develop a conceptual framework, not having the force of an accounting standard, for the purpose of
evaluating proposed accounting standards and international standards; and
b. to make accounting standards under Section 334 of the Corporations Act for the purposes of the corporations
legislation (other than the excluded provisions); and
c. to formulate accounting standards for other purposes; and
d. to participate in and contribute to the development of a single set of accounting standards for worldwide use;
and
e. to advance and promote the main objects of this Part.
Australian Securities and Investments Commission (ASIC)
The Australian Securities and Investments Commission (ASIC) administers the Corporations Act and the ASIC Act 2001.
ASIC is an independent federal government body established under the ASIC Act 2001. It acts as Australia’s corporate,
markets, financial services and consumer credit regulator and aims to develop and maintain a fair, strong and efficient
financial system for all Australians.




Improve the quality of financial reporting
Administering Corporations Act 2001 and Australian accounting standards
Independence of state ministers or state parliaments
o Otherwise it cannot fulfil its duties in terms of administering regulations
Reports to Commonwealth Parliament and Treasurer
Australian Prudential Regulation Authority (APRA)
The Australian Prudential Regulation Authority (APRA) is the prudential regulator of the Australian financial services
industry.
APRA identifies the key risks taken by an entity, ensures the risks are adequately measured, managed and monitored,
and assesses the adequacy of the entity’s financial resources to accommodate potential losses.
The aim of APRA’s supervision is to promote financial stability by requiring these institutions to manage risk prudently so
as to minimise the likelihood of financial losses to depositors, policy holders and superannuation fund members.
Australian Securities Exchange Group (ASX)
The Australian Securities Exchange Group (ASX) operates the largest securities market in Australia. Several of its
functions have implications for financial reporting practice.
The ASX establishes Listing Rules for entities that offer securities on its exchange.
The ASX oversees compliance with its operating rules, promotes standards of corporate governance among Australia’s
listed companies and helps to educate retail investors.
The ASX relies on a range of subsidiary brands to monitor and enforce compliance with its operating rules.



Main Board Rules apply to nationally listed securities
Failure to comply may lead to removal from the Board
Rules help ensure that information is disseminated in an efficient and timely manner.
International Accounting Standards (IASB)
The IASB is an independent standard-setting board that develops and approves International Financial Reporting
Standards (IFRSs).
The IFRS Interpretations Committee (formerly known as International Financial Reporting Interpretations Committee)
issues interpretations (IFRICs) and guidance for accounting standards and for specific transactions or events.
The IASB and IFRS Interpretations Committee are appointed and overseen by a geographically and professionally diverse
group of trustees (IFRS Foundation Trustees) who are publicly accountable to a monitoring board comprising public
capital market authorities.
the AASB adopted International Financial Reporting Standards (IFRSs), effective for reporting periods commencing on or
after 1 January 2005.
Political nature of setting accounting standards


Mix of private and public participation in the process
Parties that have an interest in accounting standards have conflicting interests
o Internal stakeholders - flexibility
o External stakeholders - comparability
o Auditors - objective reporting
Lobbying

Those affected by accounting standards have an incentive to lobby standard setters to achieve a favourable
outcome.

Those affected must decide:
o Whether they should lobby.
o Which method of lobbying they should use.
o When they should lobby.
o What arguments they should use to support their position.
Lobby groups





Industry and Management
o Highly motivated and resourced
Casual non-professional users
o Disparate interests, few resources
Full-time professional users
o Secretive and non-responsive
Auditors
o Accused of self-interest
Academics
o Strangely quiet
Major players in Australia seem to be:
 G100




Large accounting firms
Professional accounting bodies
ASX
Major banks
International lobbying of the IASB occurs from:
 European Union
 Asian-Oceanian Standard-Setters Group
 G20
 International Organisation of Securities Commissions
 FASB
 Other standard setters
Conceptual framework
The role of a conceptual framework of accounting is to provide guidance to standard setters in developing accounting
standards and to guide preparers on accounting issues that are not addressed by accounting standards.
The IASB’s Conceptual Framework comprises the following eight chapters.
 Chapter 1. The objective of general purpose financial reporting
 Chapter 2. Qualitative characteristics of useful financial information
 Chapter 3. Financial statements and the reporting entity
 Chapter 4. The elements of financial statements
 Chapter 5. Recognition and derecognition
 Chapter 6. Measurement
 Chapter 7. Presentation and disclosure
 Chapter 8. Concepts of capital and capital maintenance
The objective of financial reporting
Paragraph 1.2 of the Conceptual Framework states the objective of general purpose financial reporting is:

to provide financial information about the reporting entity that is useful to existing and potential investors,
lenders and other creditors in making decisions relating to providing resources to the entity.
The Conceptual Framework is designed to
 aid the development of accounting standards;
 assist financial statement preparers to develop consistent accounting policies; and
 assist all parties to understand and interpret the standards.
The Conceptual Framework emphasises that investors need information on both:
 financial performance —
o income and
o expenses
 financial position —
o assets,
o liabilities and
o equity.
Before the objective of general purpose financial reporting can be implemented in practice, the basic qualitative
characteristics of financial reporting information need to be specified. Further, it is necessary to define the basic
elements — assets, liabilities, equity, income and expenses — used in financial statements.
Qualitative characteristics of useful information
Fundamental qualitative characteristics
For financial information to be decision useful, it must possess two fundamental qualitative characteristics:
 relevance
 faithful representation.
Relevance
Paragraphs 2.6 to 2.10 of the Conceptual Framework elaborate on the qualitative characteristic of relevance.
Information is relevant if:


it is capable of making a difference in the decisions made by the users of that financial information.
it has predictive value, confirmatory value or both.
Faithful representation
Paragraphs 2.12 to 2.19 of the Conceptual Framework elaborate on the concept of faithful representation.
To be a perfectly faithful representation it must have three characteristics — it must be complete, neutral and free from
error.
Paragraph 2.19 describes measurement uncertainty as a factor affecting faithful representation. Measurement
uncertainty arises when amounts cannot be observed directly and so must be estimated.
Reasonable estimates that are clearly and accurately described and explained do not undermine the usefulness of
financial reports and even estimates with a high level of measurement uncertainty can provide useful information.
Enhancing qualitative characteristics
The Conceptual Framework (paragraph 2.23) identifies four enhancing qualitative characteristics:
 comparability
o the quality of information that enables users to identify and understand similarities in and differences
between two or more economic phenomena.
 verifiability
o a quality of information that helps assure users that information faithfully represents the economic
phenomena that it purports to represent.
 timeliness
o having information available to decision makers in time to be capable of influencing their decisions.
 understandability.
o the quality of information that enables users to comprehend its meaning. Information may be more
understandable if it is classified, characterised and presented clearly and concisely
Cost constraint on useful financial reporting
Paragraphs 2.39 to 2.43 of the Conceptual Framework note that cost is the constraint that limits the information
provided by financial reporting. The provision of information incurs costs. The costs of supplying information should not
exceed the benefits.
The role of research




Research is the ‘diligent and systematic enquiry or investigation into a subject in order to discover facts or
principles’.
Research is often repeated and adjusted, so that knowledge is expanding.
Most research studies will not provide definitive answers
Instead each study should contribute to our understanding of the issue.
Research of or about accounting


Research of or about accounting considers the role of accounting itself
It considers questions such as:
o What is the role of accounting?
o Is accounting information useful in investment decisions?
o Should accountability or decision usefulness be the key goal of accounting?
o What impact does culture have on accounting?
o What role has accounting played in the rise of capitalism or environmental degradation?
Research in accounting


Research in accounting focuses at the more micro level on issues within accounting
It considers questions such as:
o What measurements are being used?
o What measures should be used?
o What impact do changes in specific accounting policies have on share prices?