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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  • Accounting standards for financial reporting
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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.

However, the conceptual framework and accounting standards has been criticized due to being inconsistent and its lack of guidance when defining and recognising assets and liabilities. Most notably, IAS 38 Intangible Assets. Intangible assets are only recognised if it is probable that the expected future economic benefits that are attributable to the asset will flow to the entity. The general requirement in IAS 38 is similar to the requirement for Property, Plant, and Equipment of IAS 16. Conversely, in the remainder of the standard, and interrelated requirements in IFRS 3 Business Combinations, different requirements are included which could result in the recognition of intangible assets that do not meet the recognition and definition criteria of the Conceptual Framework as well as the exclusion of intangible assets that do meet the definition of an asset (Brouwer, 2015). The lack of recognising many intangible assets on financial statements due to this problem has been criticised by Lev (2003), who holds that this information is required to solve the issue of partial, inconsistent and confusing information regarding non-current assets. Eckstein (2004) concludes that the objective of providing relevant information must include the recognition of intangible assets. Disclosing the true value of intangible assets in the financial statement is fundamental in order to meet the objectives (Laux, J. (2011).

According to the recent conceptual framework of IASB, the objectives of financial reporting has two aspects. One is stewardship, which deals with management responsibility towards the company, and another is decision-usefulness, which mainly deals with the decision-making users of financial statements. The current Exposure Draft gives more prominence to the role of stewardship, which is an improvement on the existing 2010 framework (IASB 2015). This issue concerns the very nature of financial reporting, and may hinge on whether one believes that financial reports are utilized to such an extent or more for control and evaluation of management as they are for resource allocation decisions (Gore & Zimmerman 2007).

Andrew Lennard (2007) argues that stewardship and decision usefulness should be recognised as separate objectives. The assessment of how management has satisfied its stewardship responsibilities may require more information that is not necessarily provided to achieve the objective of financial reporting. Stewardship helps to increase the decision usefulness to the relevant decision maker by imposing responsibility for management to take care of the entity’s resources, thus increasing the relevance and faithful representation of the financial report. Stewardship helps to accurately record, assess managements performance, and provide information to optimise firm value, therefore improve investment decisions. Management stewardship is meaningful to financial reports users who are interested in making resource allocation decisions because managements performance in discharging its stewardship responsibilities significantly affects an entities ability to generate net cash inflows (Kuhner and Pelger 2015).

However, assessing the performance of managements stewardship through financial statements may prove difficult because of the agency problem. Some of the concern about stewardship being a separate objective seems to arise from the potential conflict between the owners and managements interest (Agrawel and Koeber, 1996). Bebchuck and Fried (2003) state that managers have a lot of influence and power over shareholders in different aspects, such as their own salary because of the ability to reduce the link between their performance and their salary. Managers have almost complete freedom allowing them plenty of opportunities to benefit for their own private interests. For example, a manager may not want to distribute excess cash when the firm does not have profitable investment opportunities, therefore, making financial statements express an inaccurate reflection of managerial allocation of resources. Boshkoska (2014) states that increasing managerial compensation will reduce the agency costs to shareholders which would make financial statements more likely to represent accurate information about a firm’s stewardship. Also, this will help support managerial and shareholder interests together, so that when shareholders benefit, managers can also benefit.

Furthermore, Kuhner and Pelger (2015) show that the concept of fair value has different impacts on the valuation and stewardship usefulness of financial statements. To clarify, fair value can display a negative impact on the ability of financial statement users to assess stewardship of the managers of the company. Lennard (2007) argues that, to be able to assess how the management discharged their responsibilities towards the shareholders, a piece of information that is difficult to disagree with is demanded. In other words, the historical cost method to value assets and liabilities is seen as a more relevant and superior measure for the purpose of relevant and faithful representative financial statements.

Different opinions continue to exist about whether providing information about management stewardship should be stated as an objective of financial reporting. A separate objective for stewardship is not required because it is comprised within the decision usefulness objective. The decision usefulness objective is to provide decision useful information to current and future providers of finance. Additionally, the same information about economic resources and claims, and changes in them, is the same information needed for assessing management stewardship. Therefore, adding a discussion about the information that is helpful in assessing stewardship would be impractical to the objective (Whittington, 2008).

To conclude, it is evident that there are limitations by using the conceptual framework and accounting standards. The limitations may make an investors’ assessment of an entities net future cash flow inaccurate. However, the contributions far outweigh the shortcomings. Without these regulations it would be impossible to produce accurate, and unbiased financial statements. Even if financial statements were slightly inaccurate, it would be impossible to predict future net cash inflows without them. Faithful representative and relevant financial information would not be possible without these accounting standards. Continued development and enhancement is recommended. With regards to stewardship, it would not be sufficient to only use financial statements to measure management responsibilities of the entity. Therefore, I believe that valuation should be considered as the main objective of financial reporting.

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