3.2.1 Understandability

Understandability is described as the presentation of information in a way that makes it comprehensible by users who have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence. However, the need for understandability does not allow relevant information to be omitted on the grounds that it may be too difficult for some. [FRS 102.2.4].

3.2.2 Relevance

Relevance is described as the quality of information that allows it to influence the economic decisions of users by helping them evaluate past, present or future events or confirming, or correcting their past evaluations. Information provided in financial statements must be relevant to the decision-making needs of users. [FRS 102.2.5].

Where FRS 102 does not specifically address a transaction, other event or condition, Section 10 – Accounting Policies, Estimates and Errors – requires an entity's management to use its judgement in developing and applying an accounting policy that results in information that is both relevant to the economic decision-making needs of users and reliable. [FRS 102.10.4].

3.2.3 Materiality

Section 2 states that information is material – and therefore has relevance – if its omission or misstatement, individually or collectively, could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor. However, it is inappropriate to make, or leave uncorrected, immaterial departures from FRS 102 to achieve a particular presentation of an entity's financial position, financial performance or cash flows. [FRS 102.2.6].

The ICAEW issued a technical release in June 2008, TECH 03/08 – Guidance on Materiality in Financial Reporting by UK Entities, which considers the issue of materiality in financial reporting and is intended to help with the practical application of the definition and explanations of materiality. It describes the determinants of materiality as the size and nature of an item, judged in the particular circumstances of the case.

3.2.4 Reliability

Reliability is defined as the quality of information that makes it free from material error and bias and represents faithfully that which it either purports to represent or could reasonably be expected to represent. Information provided in financial statements must be reliable. Financial statements are not free from bias (i.e. not neutral) if, by the selection or presentation of information, they are intended to influence the making of a decision or judgement in order to achieve a predetermined result or outcome. [FRS 102.2.7].

Where FRS 102 does not specifically address a transaction, other event or condition, Section 10 of FRS 102 requires an entity's management to use its judgement in developing and applying an accounting policy that results in information that is both relevant and reliable. [FRS 102.10.4].

Section 10 of FRS 102 further states that for information to be reliable, financial statements should:

• represent faithfully the financial position, financial performance and cash flows of the entity;
• reflect the economic substance of transactions, other events and conditions and not merely their legal form;
• be neutral, i.e. free from bias;
• be prudent; and
• be complete in all material respects. [FRS 102.10.4].

There may sometimes be a tension between ‘neutrality’ and ‘prudence’. On the one hand, financial statements must be free from bias, i.e. neutral. On the other hand, they must also be prudent, i.e. prepared with a degree of caution such that assets or income are not overstated and liabilities or expenses are not understated. See 3.2.6 below.

‘Completeness’ is discussed at 3.2.7 below.

3.2.5 Substance over form

Transactions and other events and conditions should be accounted for and presented in accordance with their substance and not merely their legal form. This enhances the reliability of financial statements. [FRS 102.2.8].

Substance over form is also a requirement of UK company law and is required by both The Large and Medium-sized Companies and Groups (Accounts and reports) Regulations 2008 (SI 2008/410) (the Regulations) and The Small Companies and Groups (Accounts and Directors' Report) Regulations 2008 (SI 2008/409) (the Small Companies' Regulations). [1 Sch 9, 2 Sch 10, 3 Sch 8, 1 Sch 9 (SC)].

3.2.6 Prudence

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. The uncertainties that will inevitably surround many events and circumstances are acknowledged by the disclosure of their nature and extent and by the exercise of prudence in the preparation of the financial statements. However, the exercise of prudence does not allow the deliberate understatement of assets or income, or the deliberate overstatement of liabilities or expenses. In short, prudence does not permit bias. [FRS 102.2.9].

For UK companies, the Regulations also require that the amount of any item must be determined on a prudent basis. In particular, only profits realised at the balance sheet date are to be included in the profit and loss account and all liabilities which have arisen in respect of the financial year in which the accounts relate or a previous financial year must be taken into account including those which only become apparent between the balance sheet date and the date on which it is signed on behalf of the board of directors in accordance with section 414 of the Companies Act 2006 (CA 2006). [1 Sch 13, 2 Sch 19, 3 Sch 18, 1 Sch 13 (SC)].

3.2.7 Completeness

To be reliable, the information in financial statements must be complete within the bounds of materiality and cost. An omission can cause information to be false or misleading and thus unreliable and deficient in terms of its relevance. [FRS 102.2.10].

3.2.8 Comparability

Users must be able to compare the financial statements of an entity through time to identify trends in its financial position and performance. Users must also be able to compare the financial statements of different entities to evaluate their relative financial position, performance and cash flows. Hence, the measurement and display of the financial effects of like transactions and other events and conditions must be carried out in a consistent way throughout an entity and over time for that entity, and in a consistent way across entities. In addition, users must be informed of the accounting policies employed in the preparation of the financial statements, and of any changes in those policies and the effects of such changes. [FRS 102.2.11].

There is more detailed guidance on comparability in Section 10 which requires an entity to select and apply its accounting policies consistently for similar transactions, other events or obligations unless an FRS or FRC Abstract specifically requires or permits categorisation of items for which different policies may be appropriate. [FRS 102.10.7]. Section 8 – Notes to the Financial Statements – requires an entity to disclose a summary of significant accounting policies, [FRS 102.8.4(b)], and Section 10 requires disclosures where there are changes in accounting policies. [FRS 102.10.13-14].

3.2.9 Timeliness

To be relevant, financial information must be able to influence the economic decisions of users. Timeliness means providing the information within the decision time frame. If there is undue delay in the reporting of information it may lose its relevance. Management may need to balance the relative merits of timely reporting and the provision of reliable information. In achieving a balance between relevance and reliability, the overriding consideration is how best to satisfy the needs of users in making economic decisions. [FRS 102.2.12].

UK companies are required by law to file accounts within specified time limits. For a private company, the period allowed by the CA 2006 for filing financial statements is nine months after the end of the relevant accounting reference period and, for a public company, the period allowed for filing is six months after the end of the relevant accounting reference period. [s442].

3.2.10 Balance between benefit and cost

Section 2 states that the benefits derived from information should exceed the cost of providing it. It is further stated that the evaluation of benefits and costs is substantially a judgemental process. Furthermore, the costs are not necessarily borne by those users who enjoy the benefits, and often the benefits of the information are enjoyed by a broad range of external users. [FRS 102.2.13].

Section 2 also asserts that financial reporting information helps capital providers make better decisions, which results in more efficient functioning of capital markets and a lower cost of capital for the economy as a whole. In the FRC's view, individual entities also enjoy benefits, including improved access to capital markets, favourable effect on public relations, and perhaps lower costs of capital. The benefits may also include better management decisions because financial information used internally is often based at least partly on information prepared for general purpose financial reporting purposes. [FRS 102.2.14].

3.3.1 Assets

The future economic benefit of an asset is its potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity. Those cash flows may come from using the asset or from disposing of it. [FRS 102.2.17].

Many assets, for example property, plant and equipment, have a physical form. However, physical form is not essential to the existence of an asset. Some assets are intangible. [FRS 102.2.18].

In determining the existence of an asset, the right of ownership is not essential. Thus, for example, property held on a lease is an asset if the entity controls the benefits that are expected to flow from the property. [FRS 102.2.19].

3.3.2 Liabilities

An essential characteristic of a liability is that the entity has a present obligation to act or perform in a particular way. The obligation may be either a legal obligation or a constructive obligation. A legal obligation is legally enforceable as a consequence of a binding contract or statutory requirement. A constructive obligation is an obligation that derives from an entity's actions when:

• by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and
• as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities. [FRS 102.2.20].

The settlement of a present obligation usually involves the payment of cash, transfer of other assets, provision of services, the replacement of that obligation with another obligation, or conversion of the obligation to equity. An obligation may also be extinguished by other means, such as a creditor waiving or forfeiting its rights. [FRS 102.2.21].

3.3.3 Equity

As equity is simply a residual figure, FRS 102 does not require that it be subdivided into any particular components although it is suggested that sub-classifications for a corporate entity may include funds contributed by shareholders, retained earnings and gains or losses recognised in other comprehensive income. [FRS 102.2.22].

However, for a UK company, the balance sheet formats of the Regulations require separate disclosure of various elements of equity. These separate components are: called up share capital; share premium account; revaluation reserve; capital redemption reserve; reserve for own shares; reserves provided by articles of association; fair value reserve, other reserves and the profit and loss account (or retained earnings).

Section 6 – Statement of Changes in Equity and Statement of Income and Retained Earnings – requires a reconciliation of each component of equity separately disclosing changes resulting from profit or loss, other comprehensive income and other transactions. An analysis of other comprehensive income by item for each component of equity is also required. [FRS 102.6.3-3A].

3.4.1 Income

The definition of income (see 3.4 above) encompasses both revenue and gains.

Revenue is income that arises in the course of the ordinary activities of an entity and is referred to by a variety of names including sales, fees, interest, dividends, royalties and rent.

Gains are other items that meet the definition of income but are not revenue. When gains are recognised in the statement of comprehensive income, they are usually displayed separately because knowledge of them is useful for making economic decisions. [FRS 102.2.25].

This split of income between revenue and gains has little meaning for accounting purposes since Section 5 – Statement of Comprehensive Income and Income Statement – requires that the format of the income statement should comply with the Regulations (or, where applicable, the LLP Regulations) except to the extent that these requirements are not permitted by any statutory framework under which an entity is required to report. In practice, this means that items of income which result from decreases in liabilities, for example a release of a provision, should be presented in the line item in which the cost was first recognised. [FRS 102.5.1].

3.4.2 Expenses

The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the entity.

Expenses that arise in the course of the ordinary activities of the entity include, for example, cost of sales, wages and depreciation. They usually take the form of an outflow or depletion of assets such as cash and cash equivalents, inventory, or property, plant and equipment.

Losses are other items that meet the definition of expenses and may arise in the course of the ordinary activities of the entity. When losses are recognised in the statement of comprehensive income, they are usually presented separately because knowledge of them is useful for making economic decisions. [FRS 102.2.26].

As discussed at 3.4.1 above, this split of expenses between expenses and losses has little meaning for accounting purposes since the format of the income statement is prescribed by the Regulations.

3.5.1 The probability of future economic benefit

The concept of probability is used in the first recognition criterion (see 3.5 above) to refer to the degree of uncertainty that the future economic benefits associated with the item will flow to or from the entity. Assessments of the degree of uncertainty attaching to the flow of future economic benefits are made on the basis of the evidence relating to conditions at the end of the reporting period available when the financial statements are prepared. Those assessments are made individually for individually significant items, and for a group for a large population of individually insignificant items. [FRS 102.2.29].

Probability as applicable to recognition in the financial statements is discussed at Section 3.9 below.

3.5.2 Reliability of measurement

The second criterion for the recognition of an item (see 3.5 above) is that it possesses a cost or value that can be measured with reliability. Reliability is discussed at 3.2.4 above.

In many cases, the cost or value of an item is known. In other cases it must be estimated. The use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability. When a reasonable estimate cannot be made, the item is not recognised in the financial statements. [FRS 102.2.30].

An item that fails to meet these recognition criteria may qualify for recognition at a later date as a result of subsequent circumstances or events. [FRS 102.2.31].

Section 2 notes that an item that fails to meet the criteria for recognition may nonetheless warrant disclosure in the notes or explanatory material, or in supplementary schedules. This disclosure is considered appropriate when knowledge of the item is relevant to the evaluation of the financial position, performance and changes in financial position of an entity by the users of financial statements. [FRS 102.2.32]. It is not clear what is meant by ‘explanatory material’ or ‘supplemental schedules’ since a complete set of financial statements includes only the primary statements and the notes to the financial statements. The notes are described as comprising ‘explanatory information’, so it seems probable that the explanatory material referred to means explanations given in the notes to the financial statements. [FRS 102.3.17].

3.9.1 Assets

Section 2 states that an entity shall recognise an asset in the statement of financial position when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably. Conversely, an asset is not recognised in the statement of financial position when expenditure has been incurred for which it is considered not probable that economic benefits will flow to the entity beyond the current reporting period. Instead such a transaction results in the recognition of an expense in the statement of comprehensive income (or in the income statement, if presented). [FRS 102.2.37].

Section 2 repeats the requirements of Section 21 – Provisions and Contingencies – that an entity shall not recognise a contingent asset as an asset but, when the flow of future economic benefits to the entity is virtually certain, then the related asset is not a contingent asset, and its recognition is appropriate. [FRS 102.2.38].

It is clear from the scope of Section 21 that the ‘virtually certain’ criteria applies only to contingent assets within the scope of that section. Assets arising from financial instruments and executory contracts which are not onerous are not within the scope of Section 21 and the ‘probable’ criterion applies to the recognition of those assets.

3.9.2 Liabilities

An entity shall recognise a liability in the statement of financial position when:

• the entity has an obligation at the end of the reporting period as a result of a past event;
• it is probable that the entity will be required to transfer resources embodying economic benefits in settlement; and
• the settlement amount can be measured reliably. [FRS 102.2.39].

A contingent liability is either a possible but uncertain obligation or a present obligation that is not recognised because it fails to meet one or both of the second or third conditions above. An entity should not generally recognise a contingent liability as a liability (see Chapter 19 at 3.4), except for contingent liabilities of an acquiree in a business combination (see Chapter 17 at 3.7). [FRS 102.2.40].

3.9.3 Income

The recognition of income results directly from the recognition and measurement of assets and liabilities. An entity shall recognise income in the statement of comprehensive income (or in the income statement, if presented) when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. [FRS 102.2.41].

Although this states that the reduction of a liability is regarded as ‘income’, this does not mean that it should be presented as ‘turnover’ or ‘revenue’ in the statement of comprehensive income. The presentation of items in the statement of comprehensive income follows either the statutory formats required by the Regulations or LLP Regulations or the ‘adapted formats’. See Chapter 6 at 6.

3.9.4 Expenses

The recognition of expenses results directly from the recognition and measurement of assets and liabilities. An entity shall recognise expenses in the statement of comprehensive income (or in the income statement, if presented) when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably. [FRS 102.2.42].

3.9.5 Total comprehensive income and profit or loss

Total comprehensive income is the arithmetical difference between income and expenses. It is not a separate element of financial statements, and a separate recognition principle is not needed for it. [FRS 102.2.43].

Profit or loss is the arithmetical difference between income and expenses other than those items of income and expense that FRS 102 classifies as items of other comprehensive income. It is not a separate element of financial statements, and a separate recognition principle is not needed for it. [FRS 102.2.44].

Generally, FRS 102 does not allow the recognition of items in the statement of financial position that do not meet the definition of assets or of liabilities regardless of whether they result from applying the notion commonly referred to as the ‘matching concept’ for measuring profit or loss. [FRS 102.2.45].

3.11.1 Financial assets and financial liabilities

As discussed in Chapter 10 at 8 an entity measures basic financial assets and basic financial liabilities at amortised cost less impairment except for:

• investments in non-derivative instruments that are equity of the issuer (e.g. most ordinary shares and certain preference shares) that are publicly traded or whose fair value can otherwise be measured reliably, which are measured at fair value with changes in fair value recognised in profit or loss; and
• any financial instruments that upon their initial recognition were designated by the entity as at fair value through profit or loss. [FRS 102.2.47].

An entity generally measures all other financial assets and financial liabilities at fair value, with changes in fair value recognised in profit or loss, unless FRS 102 requires or permits measurement on another basis such as cost or amortised cost. [FRS 102.2.48].

3.11.2 Non-financial assets

Most non-financial assets that an entity initially recognised at historical cost are subsequently measured on other measurement bases. For example, as discussed in Chapter 15 at 3.5 and 3.6, an entity measures property, plant and equipment using either the cost model or the revaluation model and an entity measures inventories at the lower of cost and selling price less costs to complete and sell.

Measurement of assets at amounts lower than initial historical cost is intended to ensure that an asset is not measured at an amount greater than the entity expects to recover from the sale or use of that asset. [FRS 102.2.49].

For certain types of non-financial assets, FRS 102 permits or requires measurement at fair value. For example:

• investments in associates and joint ventures that an entity measures at fair value (see Chapters 12 and 13);
• investment property that an entity measures at fair value (see Chapter 14);
• biological assets that an entity measures at fair value less estimated costs to sell in accordance with the fair value model and agricultural produce that an entity measures, at the point of harvest, at fair value less estimated costs to sell in accordance with either the fair value model or cost model (see Chapter 31);
• property, plant and equipment that an entity measures in accordance with the revaluation model (see Chapter 15); and
• intangible assets that an entity measures in accordance with the revaluation model (see Chapter 16). [FRS 102.2.50].

3.11.3 Liabilities other than financial liabilities

Most liabilities other than financial liabilities are measured at the best estimate of the amount that would be required to settle the obligation at the reporting date. [FRS 102.2.51].

This wording is identical to that required for provisions by Section 21 which provides additional explanatory guidance. [FRS 102.21.7]. See Chapter 19.

3.13.1 Hierarchy used to estimate fair value of shares

As mentioned above, the key guidance on how to calculate fair values is contained in the appendix to Section 2. The guidance sets out a hierarchy to estimate fair value for which the best evidence of fair value is a quoted price for an identical asset (or similar asset) in an active market. [FRS 102.2A.1]. Figure 4.1 below shows the fair value hierarchy to be used.

Reporting entities should measure fair value using the highest available level within the hierarchy. Section 2 is explicit that the best evidence of fair value is a quoted price for an identical (or similar) instrument in an active market and it is only when such quoted prices are unavailable, does an entity use the price in a binding sale agreement or a recent transaction for an identical (or similar) instrument and failing that, a valuation technique. [FRS 102.2A.1, 29]. However, the above guidance is somewhat theoretical and no examples are provided to illustrate its application, nor does the Basis for Conclusions shed any further light.

3.13.2 Quoted price in an active market

‘Active market’ is defined as ‘a market in which all the following conditions exist:

1. the items traded in the market are homogeneous;
2. willing buyers and sellers can normally be found at any time; and
3. prices are available to the public.’ [FRS 102 Appendix I].

Based on the above definition, most equities and bonds that are listed on an exchange for which there is a liquid secondary market in terms of regular trading will be considered to be traded in an active market. In addition, instruments that are frequently traded in over-the-counter markets (i.e. instruments that are not listed on an exchange), such as interest rate swaps and options, foreign exchange derivatives and credit default swaps, and for which there are available quotes may also be captured if closing prices are published.

Section 2's requirement, that the best evidence of fair value is a quoted price for an identical or similar asset in an active market, is similar to that in IFRS 13. However, FRS 102 does not reproduce the additional guidance contained in IFRS 13 that the fair value of a portfolio of financial instruments is the product of the number of units of the instrument and its quoted market price, known as ‘p times q’. [IFRS 13.80]. This guidance means that an entity which has a very large holding of an actively traded financial instrument is unable to adjust the quoted price to reflect any discount or premium that might arise if the holding were to be unloaded onto the market. Given that this guidance is not contained in FRS 102, some might read it as not to require the use of p times q in these circumstances.

3.13.3 Price in a binding sale agreement or recent transaction

The use of the price of a binding sale agreement or recent transaction for an identical instrument is a simple valuation technique. However, what requires some judgement is determining whether that price is representative of fair value or not. An adjustment is required if the last transaction is not a good estimate of fair value. This could be the situation if there has been a significant change in economic circumstances, a significant period of time between the date of the binding sale agreement or the transaction and the measurement date or the price of the transaction reflects an amount that an entity was forced to pay or receive in a forced transaction, involuntary liquidation or distressed sale. [FRS 102.2.2A.1].

3.13.4 Other valuation techniques

In addition to the use of the price of a recent transaction for an identical (or similar) instrument, other valuation techniques could include reference to the current fair value of another instrument that is substantially the same as the instrument being measured, discounted cash flow analysis and option pricing models. If there is a valuation technique commonly used by market participants to price the asset and that technique has been demonstrated to provide reliable estimates of prices obtained in actual market transactions, the entity uses that technique. [FRS 102.2.2A.2].

The objective of using a valuation technique is to determine what the transaction price would have been on the measurement date in an arm's length exchange motivated by normal business considerations. Fair value should be established using a valuation technique which makes maximum use of market inputs (i.e. inputs external to the entity) and relies as little as possible on entity-determined inputs. A reliable estimate would be achieved by a valuation technique which reasonably reflected how the market could be expected to price the asset and the inputs to the valuation should reasonably represent market expectations and measures of the risk return factors inherent in the asset. [FRS 102.2A.3].

Many entities applying FRS 102 will not enter into instruments that are required to be recorded at fair value through profit or loss and for which a quoted price in active markets is not available. However if they do invest in, or issue complex instruments that must be fair valued but do not have quoted prices in active markets, they may have to draw upon the larger body of guidance within IFRS 13 in making judgements regarding how to measure fair value, especially regarding the use of valuation techniques. Further information regarding IFRS 13 can be found in Chapter 14 of EY International GAAP 2019.

3.13.5 Fair value not reliably measurable

For assets that do not have a quoted market price in an active market, fair value is considered reliably measurable when the range of reasonable fair value estimates is not significant or the probabilities of the various estimates within the range can be reasonably assessed and used in estimating fair value. [FRS 102.2A.4]. No further guidance is provided to assess significance or probabilities in this context, hence, entities will need to exercise judgement. However, we believe that the bar for determining that a fair value measurement is not reliably measurable is relatively high as there is an expectation that it is normally possible to estimate the fair value of an asset that an entity has acquired from an outside party. [FRS 102.2A.5]. Therefore situations in which the range of reasonable estimates is significant and the probabilities of those estimates cannot be reasonably be assessed will be limited to investments such as equity holdings in private companies, for which the investee has no comparable peers.

If a reliable measure of fair value is no longer available for an asset measured at fair value, it must use as its new cost the carrying amount at the last date when the fair value was reliably measurable as its new cost. The asset will then be carried at cost less impairment, until a reliable measure of fair value becomes available again. [FRS 102.2A.6].

3.13.6 Financial liabilities due on demand

The fair value of a financial liability that is due on demand is deemed to be not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid. [FRS 102.12.11]. The logic is that a rational lender would demand repayment if the fair value were ever less than the net present value of the amount repayable, even though in practice many people do not withdraw their demand deposits in such circumstances. No guidance is provided in this context as to the appropriate discount rate, although the guidance on financing transactions would be appropriate (see Chapter 10 at 7.2). The requirement about the manner of measuring the fair value of a financial liability with a demand feature is identical to that in paragraph 47 of IFRS 13, hence, further information can be found in Chapter 14 of EY International GAAP 2019.