IFRS: Who Sets the Rules, and How Items Get In

Financial Performance & Management Control - TUHH Institute of Management Accounting & Simulation, Hamburg · part of my Technology Management MBA · study notes for revision.

---

In the first sessions we built a balance sheet for the Monopoly game, and it felt almost trivial. Every street, house and hotel had a printed price, ownership was never in doubt, and nothing had to be estimated. That is exactly why it was easy - and exactly why it was unrealistic. In a real company the two hard questions are recognition (which items are allowed onto the balance sheet at all?) and valuation / measurement (what number do we attach to them?). Neither has an obvious answer, so somebody has to write the rules.

This chapter is about those rules: who writes them (the IASB and its national cousins), what they are trying to achieve (decision-useful information for investors), how that differs from the German HGB tradition, and the decision path every IFRS standard walks through - definition, recognition, measurement, disclosure.

Reading behind these notes: Alexander and Nobes, Financial Accounting: An International Introduction (chapters 3, 5.5 and 8).

Tip

The one idea to carry through. IFRS accounting is a ladder of three decisions, always climbed in the same order: (1) is this thing an asset or a liability at all? (definition), (2) if yes, may it enter the balance sheet? (recognition), (3) if yes again, at what amount, today and in later years? (measurement). Whatever survives is then explained in the notes (disclosure). Learn the ladder once and every standard in the rest of the course looks the same.

1 · Why the Monopoly balance sheet was too easy

Ask yourself why valuing the Monopoly assets caused no headache. Three things were true at once: each item had an unambiguous price, each item was clearly owned by one player, and there was no uncertainty about whether it would still be useful tomorrow. Real businesses fail all three tests. A brand built over decades has no invoice. A pending lawsuit is an obligation whose size nobody knows. A machine bought for 1,000 might be worth 1,400 or 600 a year later. So the interesting part of accounting is not the bookkeeping mechanics from chapters 2 and 3 - it is deciding what counts and at what value. That is the job of a standard setter.

2 · The global players - who actually makes the rules

Listed (registered) companies live under a whole reporting regime: an issue prospectus when they go public, interim reports, the annual report, and timely disclosure of price-relevant news. Financial statements under IFRS are only one building block of that wider disclosure system. The regime is policed by public securities regulators, but the detailed accounting rules are written by private standard setters to whom rule-making authority has been delegated.

Internationalglobal capital markets

IOSCOthe international body of securities regulators

IASBprivate standard setter, writes IFRS

USAthe model the IASB copied

SECpublic securities regulator

FASBprivate standard setter, writes US GAAP

EUEurope, including Germany

EU endorsementIFRS become binding only once the EU adopts them

National rules staye.g. HGB for German single accounts

The global accounting players. Public regulators (SEC, IOSCO) oversee the reporting of listed companies but delegate the technical rule-making to private bodies (FASB, IASB). In the EU, an IFRS standard is applied only after an endorsement step.

The pattern to memorise: public authority above, private expertise below, delegation in between. The regulator decides that listed companies must report; the standard setter decides how.

3 · The IASB in facts

The IASB (International Accounting Standards Board) did not appear from nowhere. Its history in one line of boxes:

1973IASC founded as a private organisation

→roots in the accounting profession

until 200141 IAS issued, IASC sits inside IFAC

→restructuring

2001the new IASB is formed

→new label for new standards

since 2002standards are called IFRS (16 published)

From IASC to IASB. Older standards keep their IAS numbers (IAS 2, IAS 16, IAS 38 and so on); everything issued from 2002 onwards is an IFRS. Together the whole family is simply called IFRS.

• Origin: founded in 1973 as the IASC (International Accounting Standards Committee), a private body. The push came especially from UK chartered accountants, and until 2001 the committee was integrated into IFAC, the international federation of the accounting profession. So it began as an accountants’ club, not a government agency.
• 2001: restructured into the IASB. It now claims to be the global standard setter, with the stated goal of one single set of high-quality, understandable and enforceable global accounting standards.
• Organisation: deliberately modelled on the US FASB. A board of 14 members, at least 12 of them full-time, carries complete responsibility for technical matters, i.e. the actual standard setting.
• Output: 41 IAS by 2001, then IFRS from 2002 onwards (16 of them at the time of the course).

4 · What IFRS is for - and how HGB differs

Here is the philosophical core of the chapter. IFRS has one objective and one audience: give decision-useful information to investors on anonymous capital markets - people who have never met the management and can only judge the company through its reports. The underlying belief is a chain of three links:

Disclose everything decision-usefulabout the economic situation of the issuer

→investors can judge for themselves

Better investor protectionno hidden surprises

→prices reflect reality

More efficient capital marketscapital flows to the right firms

The IFRS logic: transparency first, judgement second. This is the disclosure philosophy nicknamed the rotten egg statute (see the Case corner below).

The German HGB comes from a different world. Its accounts serve several masters at once: information, yes, but also the calculation of distributable profit (a purpose that even colours how consolidated accounts are seen), with an eye mainly on creditors and banks rather than on anonymous shareholders. Because the readers are lenders who can ask for information directly, public disclosure is not essential in the same way.

IFRS conceptual framework

• Exclusive objective: information that is useful for decisions
• Primary audience: investors on anonymous capital markets
• Method: strong disclosure philosophy - tell everything, let the market judge
• Investor oriented, capital-market oriented financial reporting

HGB German commercial code

• Multiple objectives: information and measuring the profit that may be distributed
• Primary audience: creditors, above all banks
• Method: prudence protects lenders; disclosure is not the essential point
• The profit-distribution role also spills over into the consolidated accounts

5 · What a complete set of statements looks like

Because IFRS is about information, the consolidated (group) statements are the ones that matter - an investor buys shares in the whole group, not in one legal shell. Single-entity IFRS statements are only relevant when a company has no subsidiaries at all. A complete set under IFRS has five parts:

Component	IFRS complete set	HGB single accounts	HGB consolidated accounts
Balance sheet	yes (basic statement under the EU 4th directive)	yes	yes
Income statement	yes (basic statement under the EU 4th directive)	yes	yes
Cash flow statement	yes	no	yes
Statement of changes in equity	yes	no	yes
Notes	yes, including segment reporting	corporations only	yes, including segment reporting
Management report (Lagebericht)	not part of the IFRS set	corporations add it	added

Two things stand out. IFRS treats the cash flow statement and the statement of changes in equity as full members of the set - the equity statement returns in section 11, because it is where “silent” revaluations become visible. Under HGB the minimal single-entity set is just balance sheet plus income statement; corporations add notes and a management report, and only the consolidated accounts come close to the IFRS list.

6 · Assets and liabilities - the framework definitions

Before anything can be recognised, it has to fit a definition. The IFRS conceptual framework defines the two building blocks of the balance sheet in terms of future economic benefits - nothing about physical form, invoices or legal title.

Asset under IFRS Framework par. 49a

• A resource controlled by the enterprise
• arising from past events
• from which future economic benefits are expected
• In short: a stored future benefit

Liability under IFRS Framework par. 49b

• A present obligation of the enterprise
• arising from past events
• whose settlement will cause an outflow of resources carrying economic benefits
• Only obligations towards third parties count

Asset under HGB the German twist

• Similar idea, but with a strong focus on separate marketability (Einzelveräußerbarkeit) - can the item be sold on its own?
• Consequence: no recognition of internally generated intangibles (§ 248 II HGB)

Liability under HGB the German twist

• Similar idea, but internal liabilities (obligations of the company towards itself) are allowed in
• Consequence: provisions for expenses (Aufwandsrückstellungen) are possible (§ 249 II HGB)

The asymmetry is worth a second look. IFRS asks does the company control a future benefit? - so in principle a self-built brand qualifies (it is only kept out later by a recognition rule, see the worked example). HGB asks could you sell it separately? - and a home-grown brand fails that test outright. On the liability side, IFRS insists that someone outside the company must be owed something; HGB lets a firm set aside a provision for its own future maintenance spending, which under IFRS is not a liability at all because no third party has a claim.

7 · Measurement philosophy - neutral versus prudent

IFRS: neutral and undistorted

• Risks and chances are treated alike - good news is not suppressed, bad news is not exaggerated
• That symmetry naturally supports fair value accounting
• The framework itself lists several measurement bases without a clear favourite, but across the individual standards the IASB’s preference for fair value is easy to spot

HGB: conservatism and prudence

• Prudence is the dominant principle - measurement is deliberately asymmetric: losses early, gains late
• A rigorous historical cost principle: an asset is never carried above what it cost - cost is the upper value limit
• Logical for creditor protection: an understated balance sheet cannot mislead a lender

Same company, two balance sheets, two very different pictures - and both are “correct” within their own philosophy. When reading a German group’s IFRS report next to its HGB single accounts, this section explains most of the gap.

8 · The anatomy of a standard - the hierarchy of decisions

Almost every IFRS standard is built the same way, and the order is not cosmetic - it is the decision procedure:

1 · Definitionis the item an asset or a liability at all?

↓only if yes

2 · Recognitionmay it be entered in the balance sheet?

↓only if yes again

3 · Measurementa. initial (at recognition) · b. subsequent (later balance sheet dates)

↓and finally

4 · Disclosurewhat must be explained in the notes

The structure of an IFRS standard. Steps 1 to 3 are the central focus of accounting proper; step 4 is the information layer on top. A “no” at any step ends the climb - the item becomes an expense (or is simply not booked).

This is the hierarchy from the opening tip, written out: asset or liability? → recognise? → measure initially and afterwards? When the course later covers IAS 16 for machines, IAS 2 for inventories or IAS 38 for intangibles, each chapter is just this ladder filled in with specific rules.

9 · Recognition and measurement - what they really do

Recognition answers whether an item may be accepted into the balance sheet. The deeper meaning is that recognition is the instrument of the accrual process: every balance sheet item is, at bottom, a past or future cash flow that is parked (if it already happened) or anticipated (if it is still to come) in the balance sheet instead of hitting the income statement immediately.

Paymentcash goes out today

→recognition parks it

Assetsits in the balance sheet

→released over time

Expensereaches the income statement later

Recognition as accrual accounting in action. Without recognition the payment would be an expense straight away; with it, the cost is spread over the periods that benefit.

Measurement attaches a monetary value to what has been recognised. Here comes the subtle point: a reliable measurement is itself one of the recognition requirements. If you cannot put a dependable number on an item, it is not allowed in - so the two “steps” cannot really be separated in practice. That is exactly why the self-made brand fails in the worked example: not because it lacks value, but because its cost cannot be isolated.

10 · Two competing measurement concepts, and the four valuation bases

Once an item is in, there are two rival ideas about which number to use:

Historical cost model

• Used at initial recognition and for subsequent measurement in certain cases
• Based on a real transaction, so it is more reliable
• Downside: can drift far from what the asset is worth today

Current value model (revaluation)

• Used for subsequent measurement in certain cases
• Reflects today’s conditions, so it is more relevant to an investor
• Downside: depends on estimates, so less reliable

This is the relevance versus reliability trade-off that runs through the whole course. IFRS leans towards relevance (fair value), HGB towards reliability (cost). If a “current value” is to be used, which one? The main asset valuation bases:

Valuation base	What it means in plain words
Fair value	The amount an asset could be swapped for (or a liability settled at) between knowledgeable, willing parties dealing at arm’s length. It assumes the business is neither forced to buy nor to sell - a neutral market price.
Replacement cost	What it would cost to replace the asset today, including the transaction cost of the replacement. An entry-price view.
Net realisable value	Expected sales receipts minus any costs still needed to finish the item and to sell it. An exit-price view.
Value in use	The present value (discounted value) of the net cash flows the asset is expected to generate for the company. An internal, use-based view.

11 · Where does a revaluation gain go?

Suppose the current value model is applied and an asset is written up. The balance sheet side is simple - the asset shows the higher number. But the balancing entry can land in two very different places. Route 1, through the income statement: the value difference is booked as revenue (or as an expense, if it were a loss), net income rises by the gain, and equity rises via that profit. Route 2, directly into equity: the value difference is booked into a revaluation surplus inside equity, net income is untouched, the gain is called an unrealised gain and the treatment a neutral revaluation. Route 2 is not invisible, though: every change in equity must appear in the statement of changes in equity, so an attentive reader still finds it there - one reason IFRS insists on that statement. The worked example shows both routes with numbers.

Caution

Trap: same balance sheet, different profit. Under both routes the asset ends up at the same higher value and total equity rises by the same amount. Only the split of equity differs: retained profit (route 1) versus revaluation surplus (route 2). So two companies with identical economics can report different net incomes purely because of where the revaluation was parked. Always check the equity statement, not just the bottom line.

Worked example

Part A - securities bought for 100, fair value 140

A company buys securities for 100 (cash out 100). At the balance sheet date their fair value is 140; ignore taxes. Both routes side by side:

Effect	Route 1: gain through the income statement	Route 2: gain straight to equity
Securities (balance sheet)	100 + 40 = 140	100 + 40 = 140
Cash (balance sheet)	-100	-100
Income statement	security valuation profit (revenue) +40	nothing booked
Net income	+40	0
Equity	up 40 through the profit of the period	up 40 through a revaluation surplus +40
Character of the gain	treated as earned in the period	”unrealised” - a neutral revaluation
Where the reader spots it	income statement and equity	statement of changes in equity only

Route 1 Net income = +40 (revaluation gain booked as revenue, equity rises via profit)

Route 2 Net income = 0 · Revaluation surplus = +40 (equity rises directly, nothing in profit)

Both routes Securities = 140 · Total equity change = +40 (only the label inside equity differs)

Part B - three items climbing the recognition ladder

Now the three classic cases from the lecture, walked through the hierarchy of section 8.

1. Is it an asset? (definition)

   • Engine bought for 1,000: yes. The company legally owns it, so it controls it; the purchase is a past event; and it is expected to deliver future economic benefits.
   • Internally generated brand: yes in principle - if it is trademarked and future benefits can be expected, it meets the definition.
   • Pre-operating expenses (set-up costs of a business): no. The future benefit is usually too uncertain, so the definition already fails. The costs are charged as an expense (IAS 38.69). The climb ends here.

2. May it be recognised? (recognition)

   • Engine: yes. No IFRS forbids it, and its cost or value can be measured reliably.
   • Brand: no. Recognition is explicitly banned by IAS 38.63 because the cost of building a brand cannot be separated from the cost of developing the business as a whole. The spending is expensed when incurred. The climb ends here - a valuable asset that never reaches the balance sheet.

3. How is it measured? (measurement)

   • Engine: IAS 16 applies. Initial measurement at cost; afterwards either cost less depreciation and any impairment losses, or fair value under the revaluation model. Chapter 5 works this out in numbers.

engine = asset, recognised, IAS 16brand = asset, but recognition bannedset-up costs = not even an assetreliable measurement = a recognition test

Case corner

The “rotten egg statute” - disclosure versus merit regulation

What it means. The nickname captures the IFRS and US securities philosophy in one image: the regulator does not stop a company from selling a rotten egg to investors - it only insists that the egg is labelled as rotten. Everything decision-relevant about the issuer’s economic situation must be disclosed; the judgement about whether to buy is left entirely to the investor. Protection comes from transparency, not from a gatekeeper.

The alternative that was debated. Securities markets could instead be governed by merit regulation: an authority examines each issue, judges its quality, and can refuse permission if the investment looks unsound. The two models differ in who decides:

	Disclosure regulation (rotten egg statute)	Merit regulation (an authority judges quality)
Who judges the investment	the investor, using the disclosed information	a public authority, before the offer reaches the market
Role of the state	enforce complete, honest disclosure	act as gatekeeper and filter
Pros	respects investor autonomy; keeps markets open to risky but legitimate ventures; information feeds market efficiency; the regulator does not need to forecast business success	shields inexperienced investors from obvious junk; simpler for people who cannot read financial statements
Cons	assumes investors can and will read and understand; information overload; the sophisticated profit from the naive; disclosure does not undo a bad decision	paternalistic and slow; an authority can be wrong or captured; approval creates a false sense of safety; unusual business models may be blocked

My assessment, and the ethics angle. The rotten egg statute is honest about what a regulator can and cannot know - nobody in an office can reliably predict which start-up will succeed, so letting the market decide on full information is the more modest and, arguably, the more respectful stance. But it shifts the moral burden onto disclosure being genuinely complete and understandable. If a company technically discloses a risk in footnote 47 of a 300-page report, the letter of the rule is met while its spirit is not. Ethically, then, the model only works if managers treat disclosure as a duty to inform rather than a box to tick, and if auditors and enforcement bodies police that. It also leaves a fairness question open: a system that protects investors through information protects best those who already have the skills to use it. That is the trade-off behind the whole IFRS project - decision usefulness for investors is its strength, and the assumption of a capable investor is its blind spot.

Key terms

Term	What it means in plain words
IASC	The International Accounting Standards Committee, founded 1973 as a private body by the accounting profession; the IASB’s predecessor.
IASB	The International Accounting Standards Board, created in the 2001 restructuring; 14 members (at least 12 full-time) with full responsibility for writing standards.
IAS / IFRS	The standards themselves: 41 IAS issued up to 2001, IFRS issued from 2002 onwards. The whole family is referred to as IFRS.
FASB / SEC / IOSCO	The US private standard setter, the US public securities regulator, and the international organisation of securities regulators; the IASB is organised in the image of the FASB.
Decision usefulness	The single objective of IFRS: information that helps investors on anonymous capital markets make decisions.
Rotten egg statute	The disclosure philosophy: disclose everything relevant and let investors judge, rather than having an authority vet the quality of the investment.
Asset (IFRS)	A resource the company controls as a result of past events and from which future economic benefits are expected.
Liability (IFRS)	A present obligation towards a third party, arising from past events, whose settlement is expected to drain resources.
Separate marketability	The HGB test of whether an item can be sold on its own; internally generated intangibles fail it and stay off the HGB balance sheet.
Recognition	The decision whether an item may be entered in the balance sheet; the tool that parks a past or future cash flow instead of expensing it now.
Measurement	Attaching a money amount to a recognised item, initially and at later balance sheet dates; a reliable measurement is itself a condition for recognition.
Prudence	The HGB principle of asymmetric measurement: recognise losses early, gains late, never carry an asset above historical cost.
Fair value	The exchange amount between knowledgeable, willing parties at arm’s length, assuming no pressure to buy or sell (contrast: value in use = present value of the asset’s expected net cash flows).
Revaluation surplus	The equity line that absorbs an unrealised revaluation gain when it is kept out of the income statement.

Test yourself

1. Why was valuing the Monopoly assets easy, and which two accounting problems make real-life balance sheets hard?
2. Describe the relationship between the SEC and the FASB, and between IOSCO and the IASB. What is the common pattern, and what role does the EU play?
3. Give five facts about the IASB: its founding year and predecessor, the year of restructuring, its stated objective, its size, and its output of standards.
4. Contrast the objective and audience of IFRS with those of HGB, and explain how this difference shows up in (a) the measurement philosophy and (b) the definition of an asset.
5. Walk an engine bought for 1,000, a self-created brand and the set-up costs of a new business through the hierarchy of decisions. Where does each one fall off the ladder, and why?
6. Securities bought for 100 have a fair value of 140 at year end. Show the balance sheet, net income and equity under both possible treatments of the gain. Where would a reader find the gain in each case?

Answers

1. Every item had a printed price, clear ownership and no uncertainty about its usefulness. Real accounting struggles with recognition (which items may enter the balance sheet) and measurement (what value to attach), because prices, control and future benefits are all uncertain.
2. In each pair a public securities regulator (SEC nationally, IOSCO internationally) oversees the reporting of listed companies but delegates the technical rule-making to a private standard setter (FASB, IASB). The EU applies IFRS through an endorsement step that turns a standard into binding EU law.
3. Founded 1973 as the IASC, a private body rooted in the accounting profession; restructured into the IASB in 2001; objective: a single set of high-quality, understandable and enforceable global standards; 14 members, at least 12 full-time, modelled on the FASB; 41 IAS by 2001 and IFRS since 2002.
4. IFRS: one objective (decision-useful information) for investors on anonymous capital markets. HGB: several objectives including the measurement of distributable profit, aimed mainly at creditors and banks. (a) IFRS measures neutrally, treating risks and chances alike and leaning to fair value; HGB measures prudently and asymmetrically, never above historical cost. (b) IFRS defines an asset as a controlled future benefit from past events; HGB adds a separate-marketability test, so internally generated intangibles are excluded.
5. Engine: asset (controlled, past event, future benefit), recognised (no ban, reliably measurable), measured under IAS 16 at cost, then cost less depreciation and impairment or at fair value. Brand: meets the asset definition if trademarked with expected benefits, but recognition is banned by IAS 38.63 because its cost cannot be separated from building the business, so it is expensed. Set-up costs: fail the definition because the future benefit is uncertain, expensed under IAS 38.69.
6. Both routes: securities 140, cash minus 100, total equity up 40. Route 1: a valuation gain of 40 goes through the income statement, net income +40, visible in the income statement. Route 2: the 40 goes directly to a revaluation surplus in equity, net income 0, an unrealised or neutral gain, visible only in the statement of changes in equity.

Revision summary

Tip

The one-minute recap

• Monopoly was easy because prices, ownership and future use were certain; real accounting is hard because recognition and measurement are judgement calls, so standard setters exist.
• Players: public regulators (SEC, IOSCO) delegate rule-making to private standard setters (FASB, IASB); the EU adopts IFRS through endorsement.
• IASB: IASC founded 1973 as a private body from the accounting profession, restructured into the IASB in 2001; goal: one set of high-quality, understandable, enforceable global standards; 14 members, at least 12 full-time, built like the FASB; 41 IAS to 2001, IFRS since 2002.
• Objective: decision-useful information for investors on anonymous capital markets; strong disclosure philosophy (rotten egg statute). HGB serves several purposes (including profit distribution), focuses on creditors and banks, and cares less about disclosure.
• Complete IFRS set: balance sheet, income statement, cash flow statement, statement of changes in equity, notes with segment reporting; consolidated statements are the important ones.
• Definitions: asset = controlled resource, past event, expected future benefit; liability = present obligation to a third party, past event, expected outflow. HGB adds separate marketability (no self-made intangibles) and allows provisions for internal expenses.
• Measurement philosophy: IFRS neutral, risks and chances alike, leaning to fair value; HGB prudent and asymmetric, never above historical cost.
• Every standard: definition → recognition → measurement (initial, subsequent) → disclosure; recognition is the accrual instrument that parks a cash flow in the balance sheet, and reliable measurement is itself a recognition test.
• Cases: engine = asset, recognised, IAS 16; brand = asset but recognition banned (IAS 38.63); set-up costs = no asset (IAS 38.69).
• Historical cost is more reliable, current value more relevant; bases: fair value, replacement cost, net realisable value, value in use.
• A revaluation gain goes either through profit (net income +40) or straight to equity as a revaluation surplus (net income 0, unrealised, shown in the equity statement).

Next: Tangible Assets: PPE & Inventories → - the rules applied to machines, buildings and stock.