Regulatory environment
1 Introduction
The financial statements of a company are prepared by its directors, but they are prepared for other people – above all for the shareholders, who own the business but do not run it day to day. The directors act as agents of the shareholders, and the financial statements are the principal means by which the shareholders (and other users such as lenders, suppliers, customers, employees and governments) judge how well the business has been managed.
For the statement of profit or loss and the statement of financial position to be of any use, the users must be able to trust them. That trust does not appear by itself – it is created by regulation: laws, conceptual frameworks and accounting standards that dictate how financial statements must be prepared.
This chapter looks at why financial reporting is regulated, what the regulatory environment consists of, and who the regulators are – including the bodies that set International Financial Reporting Standards (IFRS). Two neighbouring regulatory topics belong elsewhere: corporate governance – the board's own responsibility for what is reported – is Chapter 3, and the regulatory environment of taxation, where tax rules come from and how tax authorities administer them, is Chapter 14.
Both chapter lectures were recorded under the previous syllabus. The regulatory framework they describe is still the framework, but carry three things with you.
The ISSB: the one genuinely new item for F1A1 is on neither recording — read “The International Sustainability Standards Board (ISSB)” in these notes.
Dated framing: IFRS 15 and IFRS 16 are described as “due to take effect”, and IASB/FASB convergence is framed as live. Both have aged.
Signposting: the recordings point at the old chapter shape — ethics is now Chapter 2, and the regulatory bodies are this chapter’s second lecture.
2 Why regulate financial reporting?
Left entirely to their own devices, different companies would measure and present identical transactions in different ways, and directors might be tempted to present a flattering picture of their own performance. Regulation exists to prevent this. In particular, regulation of financial reporting aims to ensure that financial statements:
are useful – they give shareholders and other users the information they need to make decisions (whether to invest, lend, supply or trade with the entity)
are comparable – the results of different entities, and of the same entity year on year, are prepared on a consistent basis and can be meaningfully compared
are reliable – they present a reasonably accurate picture of the entity's performance, position and prospects, rather than the picture the directors would prefer to paint
support stewardship – shareholders can assess how efficiently and effectively the directors have managed the resources entrusted to them
Key point
Without regulation, shareholders could place little reliance on the figures reported to them. Regulation of financial reporting protects the users of financial statements by making the information useful, comparable and reliable.
3 The elements of the regulatory environment
Three elements together make up the regulatory environment of financial reporting:
Local corporate law – each country's law (for example the Companies Act in the UK) determines which entities must prepare financial statements, when, and which set of accounting rules they must follow. Company law also deals with related matters such as distributable profits.
Conceptual frameworks – a conceptual framework is a set of fundamental principles and ideas that underpin the development of accounting standards, ensuring the individual standards are consistent with one another. Frameworks exist at both national and international level; the IASB's Conceptual Framework is covered in Chapter 4.
Financial reporting standards – the detailed accounting rules themselves, developed either internationally (IFRS) or nationally (local GAAP). Which set an entity applies depends on its local corporate law.
The two families of financial reporting standards are:
International Financial Reporting Standards (IFRS) – a single global set of accounting standards, developed from the IASB's conceptual framework and now required or permitted in well over 100 countries
Local generally accepted accounting practice (local GAAP) – accounting standards developed within one country, following that country's own framework and traditions (for example US GAAP or UK GAAP)
4 Principles-based and rules-based standards
Accounting standards can be written in two broad styles:
Principles-based | Rules-based |
Standards are developed from the fundamental principles in a conceptual framework | Standards are a set of detailed rules, with no single underlying framework |
The same principles are applied to every standard, so treatment is consistent across topics | Each rule deals with a specific situation, so similar transactions can be treated differently |
Requires the exercise of professional judgement in applying the principles | Requires little judgement – the rule is either followed or broken |
Harder to evade in spirit: a treatment that follows the letter but not the spirit of a principle is still non-compliant | Can encourage 'loophole' behaviour: transactions engineered to fall just outside a rule |
IFRS is principles-based | US GAAP is largely rules-based |
Not every country fits neatly into this split. In some jurisdictions accounting practice has historically been driven by tax law – the accounting profit is calculated largely by tax rules – rather than by a conceptual framework. You only need an awareness of this.
5 The IFRS Foundation and its boards
IFRS are produced by the IFRS Foundation, a not-for-profit organisation whose stated mission is to develop high-quality, understandable, enforceable and globally accepted standards. The Foundation's trustees do not set standards themselves – they oversee, govern and fund the bodies that do.
5.1 The IFRS Foundation Trustees
The Trustees are responsible for the governance and strategy of the whole organisation: appointing members of the boards and committees, securing funding, and overseeing the standard-setting process (though not its technical content). The objectives of the Foundation are to:
develop a single set of high-quality, understandable, enforceable and globally accepted accounting standards
promote the use and application of those standards
take account of the financial reporting needs of emerging economies and of small and medium-sized entities
promote the convergence of national accounting standards with IFRS
5.2 The International Accounting Standards Board (IASB)
The IASB is the independent standard-setting board responsible for IFRS Accounting Standards. Its members are appointed primarily for their technical expertise and practical experience. The IASB has complete responsibility for all technical matters, including:
the preparation and publication of IFRS Accounting Standards
the publication of exposure drafts (draft standards issued for public comment)
the withdrawal of standards that are being replaced
final approval of the interpretations developed by the IFRS Interpretations Committee
5.3 The International Sustainability Standards Board (ISSB)
In 2021, at the COP26 climate conference, the IFRS Foundation created a second board: the International Sustainability Standards Board (ISSB). The ISSB sits alongside the IASB as a sister board and is responsible for IFRS Sustainability Disclosure Standards – standards that require companies to report sustainability-related information (such as climate-related risks and opportunities) that is useful to investors. Its first two standards are IFRS S1 (general sustainability-related disclosures) and IFRS S2 (climate-related disclosures).
The ISSB consolidated earlier voluntary sustainability-reporting initiatives. In particular, the International Integrated Reporting Council (IIRC) and the Sustainability Accounting Standards Board (SASB) had merged in 2021 to form the Value Reporting Foundation, whose work was then absorbed into the IFRS Foundation when the ISSB was formed.
Exam focus
For F1 you need an awareness of the ISSB: what it is, that it sits under the IFRS Foundation alongside the IASB, and that it issues IFRS Sustainability Disclosure Standards (IFRS S1 and S2). The detail of sustainability reporting is examined later, in F2.
5.4 The IFRS Interpretations Committee
The Interpretations Committee reviews newly identified financial reporting issues and issues guidance on how the standards should be applied to them. Its interpretations require the final approval of the IASB.
5.5 The IFRS Advisory Council
The Advisory Council is the formal channel through which the Trustees and the boards consult the outside world. It brings together national standard-setters, academics, preparers, users and other interested parties, and both gives advice and passes back the concerns of those it represents.
6 Other bodies that influence financial reporting
International Organisation of Securities Commissions (IOSCO) – the international body of the world's securities market regulators (the regulators of stock exchanges such as London and New York). Because listed companies are the main users of IFRS, IOSCO's endorsement of IFRS for cross-border listings gave the standards much of their global authority.
National standard-setters – bodies such as the Financial Accounting Standards Board (FASB), which sets US GAAP. For a number of years the IASB and FASB worked together on a formal convergence programme to narrow the differences between IFRS and US GAAP; joint standards on revenue and fair value came out of that work, although full convergence was never achieved.
Stock exchange regulators – an exchange's listing rules can impose reporting requirements on listed companies over and above those in accounting standards or company law.
7 The standard-setting process
A new IFRS Accounting Standard is developed through a transparent due process, with public consultation at every stage:
Agenda consultation and research – issues are raised (by the Advisory Council, national standard-setters and others) and the IASB adds projects to its work plan
Discussion Paper – the issue and the possible approaches to it are set out for public comment
Exposure Draft – a draft of the proposed standard is published, and anyone may comment on it
New IFRS Accounting Standard – the IASB considers the comments received, then issues the final standard with an effective date (sometimes deferred to give preparers time to change their systems)
Regulatory bodies
Which ONE of the following would NOT be regarded as a responsibility of the IASB?
A Responsibility for all IFRS technical matters
B Publishing IFRS Accounting Standards
C Acting as the overall supervisory body of the IFRS organisations
D Final approval of interpretations issued by the IFRS Interpretations Committee
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The regulatory environment consists of local corporate law, conceptual frameworks and financial reporting standards. IFRS Accounting Standards are principles-based and are set by the IASB, under the oversight of the IFRS Foundation Trustees, supported by the Interpretations Committee and the Advisory Council. Since 2021 the Foundation has had a second board, the ISSB, which sets IFRS Sustainability Disclosure Standards (IFRS S1 and S2). IOSCO and national standard-setters such as the FASB also influence financial reporting. New standards pass through research, a discussion paper and an exposure draft before being issued.
8 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Regulatory environment
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