Essay: Accounting standards for financial reporting

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  • Subject area(s): Accounting essays
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  • Published on: August 9, 2018
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The conceptual framework and accounting standards for financial reporting provides an agreed set of fundamental principles and concepts that leads to consistent standards to ensure that these principles are met accordingly and the information required by users are faithfully represented and relevant (FASB, 2010). These standards are required in order to ‘’assess managements stewardship and make informed economic investment decisions’’ (Elliot & Elliot, 2017). The purpose of this essay is to critically evaluate how the conceptual framework and accounting standards are facilitating the reporting of ‘’relevant and faithfully represented’’ information in the entities financial statements that are useful in assessing the prospects for future net cash inflows to the entity. Specifically, this essay will evaluate the objectives of financial reporting, ‘valuation usefulness’ and ‘stewardship usefulness’. Also, the importance of reporting relevant and faithfully represented information within the conceptual framework will be discussed in depth.
 
The conceptual framework and accounting standards state the qualitative characteristics of financial information that is required to reflect truthfully a company’s financial performance (IASB, 2010). Relevant information is capable of making a difference to a user’s decision. Relevant information has predictive value because it helps users to evaluate the potential effects of past, present, or future transactions or other events on future cash flows (Nobes and Stadler, 2015). In addition to predictive value, confirmatory value contributes to the relevance of financial reporting information. If the information in the financial report provides feedback to the users regarding previous transactions or events, this will help them to confirm or change their expectations (Jonas & Blanchet, 2000) (Christensen, 2010). Faithful representation is the second fundamental qualitative. To faithfully represent economic phenomena that information purports to represent, financial information must be neutral, complete, and free from error (IASB, 2010).

However, the quality of ‘transparency’ is not directly mentioned in the Exposure Draft. In practice, it is often referred to in the context of good financial reporting. A study from Nobes and Stadler (2015) regarding the usefulness of qualitative characteristics, showed that preparers frequently refer to transparency in the context of policy changes under IAS 8.

IAS 1 states that the primary objective of financial reporting is to provide information that is useful to those making investment decisions, such as buying, selling or holding equity investments (Gore & Zimmerman 2007). Given that valuation usefulness is seen as the dominant role of contemporary financial reporting (Zeff, 2013), it is rather unsurprising that financial statements are found to be very useful to investors and other creditors when valuing a firm. The conceptual framework provides accurate and timely financial information, relevant to the accounting standards for investors and stakeholders (Ball,2006). This should lead to more-informed valuation in the equity markets.

A major feature of the conceptual framework and accounting standards that facilitates the reporting of relevant and faithfully represented information is the concept of fair value (IFRS 13). Hermann (2006) states that fair value is the most relevant measure of financial reporting. IAS 16 provides a fair value option for property, plant, and equipment and IAS 36 requires asset impairments and reversals adjusted to fair value. Under the fair value measurement approach, assets and liabilities are re-measured periodically to reflect changes in their value, resulting a change in either net income or other comprehensive income for the period.

In addition, fair value meets the conceptual framework criteria in terms of qualitative characteristics of accounting information better than other measurement bases. Fair value makes financial information relevant because current prices are reliable measures of value as it reflects present economic conditions that is related to economic resources and obligations (Barth, 2008). Also, according to Hermann (2006), fair value is more relevant to decision makers. Fair value makes an entity’s financial information faithfully represented because it accurately reflects the condition of the business. Management and entities may sometimes rearrange asset sales and use the gains or losses from the sales to over or understate net income at a current time. Fair Value prevents entities from manipulating their reported net income as gains or losses from price changes are reported in the period in which they occur. As pointed out by Ball (2006), this results in a balance sheet that better reflects the current value of assets and liabilities. However, the use of fair values results in an unavoidable trade-off between relevance and reliability of accounting standards and could increase manipulation opportunities in highly liquid markets (Marra, 2016) (Barth, 2008).

Moreover, IAS 1 requires entities to prepare its financial statements, except for cash flow information, using the accrual basis of accounting (IASB 2010). Accrual accounting is a method which measures the performance of a company by recognizing economic events regardless if any cash transaction occurs. The accruals concept gives entities a better assessment and understanding of future net cash flows, thus enabling managers to make more informed financial decisions. The accrual basis informs users about obligations to pay cash in the future and of economic resources that represent cash to be received in the future. Just like fair value, Accrual accounting also meets the framework criteria of qualitative characteristics. Accrual accounting enables predictability as it helps users evaluate the potential effects of past, present or future transactions or future cash flows, and confirmatory value to confirm or correct their previous evaluations. Accrual accounting produces more faithfully represented financial statements as it constitutes better representations of actual circumstances and the entities performance in any time period. There is evidence that as a result of the accruals process, reported earnings tend to be smoother than underlying cash flows and that earnings provide better information about economic performance to investors than cash flows (Dechow 1994).

Overall, both the accruals and fair value concept makes financial statements relevant and faithfully represented, Therefore, making valuation more useful as investors are able to accurately assess the prospects for future net cash flows. In fact, it would be tough to identify better alternative methods in order to meet the requirements of the qualitative characteristics from accounting standards and the conceptual framework.

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