I am going to analyse and evaluate the conceptual and regulatory framework of financial reporting. In order to do this I will look at the objective of financial statements, identify the users of financial statements, explain the conceptual framework for financial reporting, look at the regulatory framework for financial accounting and finally look at the three ways of achieving accounting comparability. According to IAS Plus website, 2011, the objective of financial statements is; ‘to provide information about the financial position, financial performance, and cash flows of an entity that is useful to a wide range of users in making economic decisions’ This objective is what all entities are aiming to achieve when creating their financial statements. There are two types of framework put in place to help the company to achieve this objective. The two types of framework are conceptual framework and regulatory framework. In order for the financial statements to meet their objective they must follow the conceptual framework.
Conceptual framework is, ‘not an accounting standard, sets out the principles and concepts that underlie the preparation and presentation of financial statements for external users’ (Gupta. A, p.146, 2008) Conceptual framework is basically a set of rules on the preparation and presentation off financial statements. The conceptual framework ensures that all financial statements are created correctly and are understandable. They assist many people such as; 1. ‘Preparers in applying accounting standards and in dealing with topics that have yet to form the subject of an accounting standard. 2. Auditors in forming an opinion as to whether financial statements conform to accounting standards, or not. 3. Users in analysing and interpreting the information contained in financial statements prepared in conformity with accounting standards, and 4. The Accounting Standards Board (ASB) of the ICAI in development of future accounting standards and in its review of existing ones relating to the preparation and presentation of financial statements for reducing the number of alternative accounting treatments permitted by accounting standards.’ (Gupta. A, p.146, 2008)
The conceptual framework is issued by the International Accounting Standards Board and is therefore closely linked with the Accounting Standards. Following the conceptual framework assists in the creation and review of accounting standards. Without the conceptual framework, there would be no unity in the creation of financial statements. Financial statements are produced to assist the users of financial statements in decision making, for example, creditors and lenders. However, these aren’t the only two users of financial statements; there are both internal and external users of financial information.
The internal users of financial statements are; * Managers such as, market manager, production supervisor, finance directors and company officers- these need financial statements in order to make decisions on planning, and organisation. In addition to all other decisions that assist in the running of the business. * Owners- the owners of the business need to know how the business is performing and what their financial position is. * Workforce- the workforce view financial statements to help gain an idea of the companies financial health. The external users of financial information are;
* Investors- they need to view financial information in order to make decisions on whether to sell, hold or buy more stock. * Creditors- creditors are suppliers and banks, they view financial information in order to evaluate the risk of selling on credit or lending money. * Government- the government use financial statements of a company to help determine their taxable income, make decisions on government grants and to assist with controlling the companies compliance with regulations. The financial statements must be useful for all the users; this is done by ensuring the qualitative characteristics of financial statements are met. The qualitative characteristics are; ‘the attributes that make information provided in financial statements useful to others’ (Kaplan, p.142, 2011) According to the conceptual framework there are four qualitative characteristics. These four characteristics are;
However, in order to meet all of these characteristics materiality must be achieved first. Materiality is not classed as one of the qualitative characteristics, if any information does not meet the objective of materiality then it needs not be considered for the financial statement. Therefore if something is not considered as material it then cannot be of use, relevant, reliable, comparable or understandable. I am going to look at each characteristics in more detail in order to understand why these characteristics are important to the preparation and creation of financial statements. Understandability
Understandability is ensuring that the financial statements are understandable to the user, if the user can not understand the information then the objective has not been met. The understandability of financial statements varies on the ability of the user, therefore a reasonable knowledge of business and accounting has to be assumed. However, no information should be excluded based on the fact it may be too difficult for the average user to understand. All relevant information must be included. Relevance
Relevance is ensuring that the statements are tailored to then needs of the users. This can be the most time consuming characteristic as the business has many different users with different needs. In order to meet the needs of all the users a statement must be created tailored to each one of the users. For example, if a manager requests information based on the sales of a new product they expect the financial statements to tell them how that particular product is performing. This information will then assist the manager in making a decision on whether to keep that product or to scrap it. Reliable
Reliable information must have the ability to be depended upon by the users to have faithful information, to do this the information but be free from error and bias. Although information is relevant it can still be seen bias, therefore making it unreliable as it could be misleading. The reliability of financial statements is dependant upon, faithful representation, substance over form, neutrality, completeness and prudence. In order to gain a fully faithful representation all financial information must conform with legal requirements, conform with accounting standards and have applied all the the qualitative characteristics. Prudence is being cautious when making judgements when arriving at estimations. When preparing information for financial statements, many judgements and estimations have to be made.
According to Kaplan (p.145, 2011) uncertainty can be dealt with by; ‘disclosing the nature and extent of the uncertainty involved and by excercising prudence’ However if there is not uncertainty surrounding the information provided the prudence need not be exercised. Neutrality is keeping the information from being bias. This is because many judgements have to be made on things such as, valuing stock and fixing depreciation levels. If these are recorded with a bias head it causes the information to be misleading to the users and therefore not faithful or reliable. Information cannot be reliable if its bias. All financial statements must be complete, incomplete statements can be seen as unreliable. If this is the case they are not meeting the objective of financial statements. Comparability
Comparability, according to IASB (p.85,2009)
‘Users must be able to compare the financial statements of an entity through time in order to identify trends in its financial position and performance. Users must also be able to compare the financial statements of different entities in order to evaluate their relative financial position, performance and changes in financial position.’ The ability to compare financial statements helps the user to understand more about the financial statements and also see the relevance of the information provided. Meeting the criteria of comparability helps the entity to meet the objective of financial statements. The conceptual framework also looks at the concepts of capital and capital maintenance. Capital maintenance concepts are all about a return on invested capital, this occurs after the amount invested has been maintained or recovered.
There are two concepts these are, financial concept of capital maintenance and a physical concept of capital maintenance. Financial capital maintenance occurs at the end of a financial period, the entity looks at the financial amount of net assets at the end of the period and compares it to the net assets at the beginning of the period, if the end amount is greater minus any distributions to and contributions from owners, then the starting amount then the entity has made a profit. Physical Capital maintenance also occurs at the end of a financial period, however, this time the entity looks at the physical productive capacity at the end of the period and compares it to that at the start of the period, again if the ending amount is greater minus any distributions to and contributions from owners, then again the entity has made a profit. The Regulatory Framework
Regulatory framework links with the International Accounting Standards Board. The regulatory framework for the preparation of financial statements is a set of rules, known as accounting standards put in place with the help of conceptual framework to ensure that all financial statements are reliable, useful and not in any way misleading. It also ensures that they are understandable for each user. However, there isn’t just one set regulation in the preparation of financial statements; the regulatory framework can vary nationally and internationally. National characteristics can change the way in which a business produced their financial statements. According to Alexander, Britton and Orissen (2007, p.25) ‘the accounting policies or accounting decisions of a company were, and still are to a large extent, influenced by the national environment and national accounting standards and practices’
There are reasons for national characteristics having an impact on how financial statements are produced, some of the factors pointed out by Gibson (2011, p63) are as follows; 1. ‘A litigious environment in the United States that has led to a demand for more detailed standards in many cases. 2. High rates of inflation in some countries have resulted in periodic revaluation of fixed assets and other price-level adjustments or disclosures. 3. More emphasis on financial reporting/income tax conformity in certain countries (for example, Japan and Germany) that no doubt greatly influences domestic financial reporting. 4. Reliance on open markets as the principle means of intermediating capital flows that has increased the demand for information to be included in financial reports in the United States and some other developed countries.’
All these issues above may affect the way that financial transactions are recognised, recorded, measured and communicated. Differences in the production of financial statements can cause many problems the main problem being that differences in accounting systems are; ‘an obstacle towards the comparability of financial information published by companies using different sets of accounting standards.’ (Alexander. D, Britton. A, Orissen. A, 2007, p.23) Comparability is one the qualitative characteristics needed to meet the objective of financial statements, the only way that a company using national standards would be able to achieve its full comparability it would have to produced more than one version of its financial statements. For example, if an entity wanted to trade internationally but used national standards to create its financial statements they would have to produced financial statements using international standards also in order to attract investors and gain overseas suppliers.
In order to try to make all entities more comparable the International Accounting Standards Board are trying to converge the accounting industry, Ross Roundtable reported on this stating; ‘Harmonisation and convergence have both been used to describe the efforts by the United States and European countries to move towards a global financial accounting infrastructure.’ Harmonisation accommodates national differences whereas convergence is all about merging together to create one common result, that result being global accounting standards. Doing this will enable entities to be more comparable, globally, without having to produce numerous financial statements. The lack of harmonisation doesn’t just cause problems with comparability there have been other problems linked with this. Some of which Gibson (2011, p.62) mentions;
1. ‘A need for employment of key personnel in multinational companies to bridge the “gap” in accounting requirements between countries. 2. Difficulties in reconciling local standards for access to other capital markets. 3. Difficulties in accessing capital markets for companies from less developed countries. 4. Negative effect on the international trade of accounting practice and services.’ In order to rectify these problems it costs the entity money, as it will prevent international investors from approaching them as they have nothing to compare the company to in order to make a safe decision. In addition to this, extra personnel is needed to help bridge the gap, therefore adding extra costs such as, wages. Convergence has been briefly mentioned above, but I am going to look at convergence and why the International Accounting Standards Board thinks that converging accounting standards is the way forward.
Converging accounting standards will create one global set of accounting standards, in order to gain comparability the International Accounting Standards Board have deemed this a necessity. Converging will not only gain comparability it will gain global comparability. According to Frederick, Choi, Meek (2005, p.279) ‘Many countries as of financial statements starting in 2005 gave already converged. These countries are all European Union listed companies, following the IFRS, also Australia and New Zealand have adopted the IFRS as their own GAAP. The USA is also converging their own accounting standards with IFRS to the maximum extent possible. Canada and many Asia-Pacific countries starting to converge their national generally accepted accounting principles (GAAP) with IFRS.’ One of the main advantages of the convergence is; not only comparability but also international investment.
Yoon (2005, p.2) Stated; ‘investors in these countries go to international markets in order to take advantage of capital investment opportunities. International investors require comparable financial statements because financial statements prepared with different accounting principles impede good international investment decision making.’ In addition to increasing international investment and comparability, convergence will show structure within the accounting industry as having global standards with bring financial reporting together worldwide, showing unity. Another way of increasing comparability is standardisation; standardisation implies the imposition of a rigid and narrower set of rules. Standardisation would mean that there would only be one technically correct method identified for each aspect of accounting. I think this approach to trying to gain greater comparability would be least likely to happen.
This is because, during this assignment I have looked at national characteristics and how they influence financial statements. After doing this there is too much going on nationally for each country for there to be just one correct method identified for each individual aspect of accounting. In conclusion, the regulatory and conceptual framework, assist in the preparation of financial statements, however, there is no one way of producing a financial statement, and to some extent the methods used in producing the financial statement is the choice of the manager. Having more than one set of accounting standards in place to create the financial statements is holding companies back from trading internationally and also costing businesses more in the long run than it would if the accounting standards were to converge and harmonise.
On the other hand due to national characteristics, some countries would prefer the accounting standards to harmonise as this will take into consideration the national standards also. The advantages of harmonisation are, increased comparability, helping to eliminate misunderstandings, and increasing international investment, less time and money spent in consolidating divergent financial information and auditing quality would be improved. Converging is also a possibility and as shown above some countries have already taken then steps to converge to the International Financial Reporting Standards. This could mean that eventually there will be one set of standards used worldwide, meaning that greater comparability will be achieved.
The final way of achieving greater comparability is through standardisation, however, after looking at harmonisation and convergence, I don’t think that standardisation will be successful. Just one set way of doing everything will not work for everyone. One the other hand if there was just one set way of preparing every aspect of a financial statement then the maximum amount of comparability would be achieved. At the moment the main points being mentioned when you look at conceptual and regulatory framework is convergence and harmonisation. After looking at the facts, I think that this is the direction that then International Accounting Standards Board are most likely to take whan aiming to achieve comparability.
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