ASB'S Framework for Preparation and Presentation of Financial Statements - Research Paper Example

Running head: IASB'S FRAMEWORK FOR PREPARATION AND PRESENATATION OF FINANCIAL STATEMENTS IASB'S Framework for preparation and presentation of Financial Statements Abstract: The report aims at the description and analysis of the framework for the preparation and presentation of financial statements as provided by the IASB. The report will also examine certain accounting concepts, underlying assumptions and (qualitative) characteristics. The report will also examine the importance of applying the appropriate concepts or assumptions in the preparation of financial statements in different entities. It will further elaborate how accounting for inventories will change according to these concepts/assumptions. "The board of the International Accounting Standards Committee (IASC), a 13-member (all part-time) organization representing professional accounting groups (e.g., the AICPA) from member countries, promulgated IAS beginning in the mid-1970s. By the end of 2000, the number of IASC member countries had grown from 10 charter members to 134. Effective April 1, 2001, the board of the IASC handed over responsibility for standards-setting to a new organization, the International Accounting Standards Board (IASB), appointed by newly established IASC trustees." (Campbell et al., 2002) Framework for the Preparation and Presentation of Financial Statements: "IFRS 1 first time adoption of International Financial reporting Standards. IFRS 2 Share based payments IFRS 3 Business combinations IFRS 4 Insurance Costs IFRS 5 Non-Current assets held for sale and discontinued operations IFRS 6 Exploration for the evaluation of mineral resources IFRS 7 Financial Instruments: disclosures" (BPP, 2008; pp. 71) IAS 1 identifies four fundamental assumptions that must be taken into account when preparing financial statements: Fair Presentation Going concern Accruals Consistency Three more important concepts which are identified by IAS 1 are Prudence, substance over form and materiality. These concepts form the basis of the selection and implementation of the accounting policies. The basic purpose of the framework presented by the IASB is to provide the definition of why the financial statements are required. It also ascertains the qualitative characteristics that eke the process of making the information provided by the financial statements more useful. The framework also elaborates about the basic elements included in the financial statements and the concepts for recognising and measuring them in financial statements. Why is Financial Statement required? The general purpose financial statement is required to provide information regarding the financial position including the cash flow and performance of the company. The information provided in the financial statement helps a company in comparing its performance from the last year and supports the management in undertaking important decisions regarding the business. The purpose can only be fulfilled if the financial statements provide information regarding the following aspects of the company. Assets Liabilities Equity Income and Expenses Other changes in equity Cash flows The financial statement prepared in accordance with the IAS 1 will include the following components: a) Balance Sheet b) Income statement c) Equity changes statement d) Cash flow statement e) Accounting policies and explanatory notes With the information regarding the above aspects other information in the notes and related documents help the users in estimation and evaluation of the present and future position of the entity. The framework provided by the IASB addresses the general purpose financial statements prepared by every business entity for addressing the information requirements of a wide range of users in making economic decisions. As the framework addresses the purpose of preparing the general financial reports it may not apply to the special purpose financial reports. It is obligatory under the IASB framework that the financial statement of an entity should serve the information purpose of the different kinds of users including the employees, investors, regulatory bodies, investors, customers and common people as the financial statement is the only source of information regarding the present and future condition of the company. The major concern of the potential or present investor is to analyse the cash and cash equivalent generating capability of the company and their continuation in future. It is also obligatory under the IASB framework to provide the investors with the information required by them in order to asses the financial position of a company as the investors are those who provide the company with the risk capital. The general purpose financial statements fulfil the requirements of providing the information of general level to all user groups. The information provided in financial statements is historic in nature. It can only be used to evaluate the past performance of the company. On the other hand the users of the financial statements have to undertake the decisions which are related to future. The financial statements also lack the provision of non-financial information which can be useful for the users in order to take decisions. Financial Position: A company's financial position can be better judged by going through its balance sheet. The balance sheet provides the information regarding the true financial position of an entity including the financial structure, liquidity and solvency ratios, condition of the assets held by the company and the flexibility of the company to undertake change according to the requirements of business environment. Performance: The profit generating capability of an enterprise by undertaking investment on resources is known as the performance. The information provision regarding the profit patterns of the organisation helps the user in understanding the potential cash flow in future from the current resources and addition of resources in future. The income statement of an entity provides information regarding the performance of an organisation. Changes in Financial Position The cash flow statement provides information regarding the cash generation and use of cash equivalents by the company during the reporting period. With the help of the cash flow statement the user will be able to predict the future cash flow of the entity. Notes and Supplementary Schedules The complimentary information which supplements the information regarding the main elements of the financial statements is mentioned in the notes and supplementary schedules. These notes and supplementary schedules also provide information regarding the risks and uncertainties affecting the enterprise. The IASB Framework also discusses the fundamental assumptions on which the financial statements are prepared: Accrual Basis. The transactions and other events are recorded and reported as soon as they are happened rather then recording them at the time of cash receipt or payment (Barth, et al., 2001) Going Concern. It is assumed that the enterprise will continue in operation indefinitely on the other hand if the assumption is not applicable disclosure should be undertaken. Qualitative Characteristics of Financial Statements: The IASB framework not only makes it obligatory for the business entities to provide information but also ensure that the quality of information should be such that it is useable by the investors, creditors, and other potential users of the information. To ensure the usability it is mandatory for the financial statements to have following characteristics Understand ability Relevance Reliability Comparability Understand ability The information presented in the financial statements should be easy to understand by the users who have a background in understanding the business and economic activities and whose decisions are based on the thorough assessment of the information contained in the financial statements. Relevance Relevance of information contained in the financial statements is also essential in order to help the users in undertaking their decisions. The information can be characterised as relevant if it can effect the decision making of its user. Relevant information not only helps the users in undertaking the evaluation of past and present performance of the entity but will also help in confirmation or correction of the evaluations previously undertaken. If the change in the information can effect the decision, the information has materiality. The timeliness of information improves the relevance of the information. The information should be provided to user at the time when it is most useful for the user in undertaking the decision. Reliability The unbiased and error free nature of the information makes it reliable in reporting the transactions undertaken by the entity. The biased nature of information in a significant direction decreases the degree of reliability of information. The use of different estimation methods and uncertainties effecting the valuation and recognition of items in financial statements can be minimised by the disclosure and applying prudence while preparing the financial statements. Prudence can be defined as" the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated." (ACCA Study Text, 2008; p. 87) It is not justified to create secret or hidden reserves using prudence as a justification. It is also not justified to overstate liabilities or expenses and understate assets or income as it will affect the neutrality and reliability of financial statements. Comparability The information provided in the financial statements regarding the business entity should be comparable with respect to time. The characteristic of comparability helps the user in undertaking the evaluation of the performance and financial position of the company. The information should be comparable with other business entities also so that the users can evaluate the comparative performance of different organisations. The financial statements should also provide information regarding the accounting policies being practised in the organisation. The Elements of Financial Statements: All the transactions or events are reported in the financial statements under the broad categories of Assets, Liabilities, Equities, Income and Expenses. This categorization is undertaken according to the economic characteristics of the transactions and events. The Assets, Liabilities and Equities are the elements which present information regarding the financial position of the company while income and expenses are the indicators of performance of the entity. Below the definitions of the elements of financial statements are provided. Asset can be defined as the resources held by the business entity in order to acquire economic benefits in future. Liability is the responsibility of the entity resulting from the past transactions which can be settled through the outflow of resources representing economic benefits. Equity is the residual interest in the assets of the enterprise after deducting all its liabilities. Income can be defined as the increment in the economic benefits or cash inflow or increment in the asset value or decrease in the liabilities of the entity which result in shape of the increment in equity. Expenses can be defined as the decrease in the economic benefits of an entity in a specific accounting period. This can be in shape of the cash outflow or decrease in the liabilities of the entity. The income of the entity comprise of the revenues and gains. The gain in result of ordinary activities of business can be a variety of inflows in shape of sales, consulting fees, interest earned on the capital, dividends on shares, and rent on property. On the other hand gains are all the other income not resulting from the ordinary activities. The IASC framework considers gains and revenues as the same element. Expenses are the losses or the expenses due to the ordinary activities undertaken in the enterprise. The expenses in result of ordinary activities of business can be a variety of outflows in shape of costs of sales, employees' wages, interest paid, dividends on shares, and depreciation on plant. The expenses are the outflows from the business or reduction in the assets including cash and cash equivalents, inventory, property, plant and equipment. The IASC framework considers losses and expenses as the same element. Recognition of the Elements of Financial Statements The item is recognised in the balance sheet or income statement of an entity if there is an expectation of future economic benefit to flow in or out of the entity and its value can be measured on reliable basis. Based on these general criteria: The asset of an entity should be recognised in the balance sheet if there can be an expectation of economic gain and the asset has a reliable value which can be measured. The liability of an entity should be recognized in the balance sheet if there is a probability of outflows from the resources when it is probable that an outflow of resources representing the economic benefits needs to be undertaken in order to undertake the settlement in response of a compulsion and the measurement of amount can be undertaken on reliable basis. Income is recognised in the income statement when a reliably measured increment in asset or decline in the liability has been taken place. On the other hand Expenses are recognised in the income statement when a reliably measured decline in asset or increment in the asset has been taken place (Barth et al., 1994) Measurement of the Elements of Financial Statements: The IASB framework provides different measurement basis which can be used to calculate and assign monetary values to the elements stated in the financial statements. There are several frameworks which are recognised by the framework. These are used singularly and in combination in varying degrees requirements of the entity. Historical cost Current cost Net realisable value Present value Although the framework does not specify the selection and use of any measurement criteria to be used in the financial statements but the historical cost measurement basis is the most prevalent practise in most of the entities. Accounting for Inventory: Inventory is the stock of goods held by the business entity either for sale, for further manufacturing, work-in-process or finished goods. Inventory is an important item in the financial statement while analysing the profit or loss of the entity. The inventory process can be best understood by going through the following formula: Cost of Goods Sold, the Inventory formula: Beginning Inventory $XXX.XX Add purchases during the month + XXX.XX Subtract ending Inventory - XXX.XX Cost of Goods Sold $XXX.XX It is very important to calculate the costs of goods sold. The profit for a given accounting period can be realised by calculating the exceeded amount after paying the costs of goods sold, overhead expenses and the payment to the entrepreneur. The accuracy in the determination of Cost of Goods Sold (COGS) is important. The COGS can be found verily according to the “periodic” or “perpetual” system of recording inventory. Periodic: In the periodic inventory accounting purchases are recorded at the debit side of Purchases account. The inventory has to be counted physically to determine the quantity left to be sold. The quantity is then priced and recorded in order to determine the COGS. Perpetual: In case of the perpetual accounting system the purchases are recorded in the debit side of Inventory account. In case of a sale the item is charged on the credit side of inventory and a corresponding entry is made at the debit side of COGS account. The physical inventory count is not necessary in order to determine the quantity left to be sold (Barth et al., 1995) . References: BPP, (2008). F3 Financial Accounting, ACCA Study Text, BPP learning Media, pp.71 Barth, M. E., and C. M. Murphy. (1994).Required disclosures: Purposes, subject, number and trends. Accounting Horizons (December). Barth, M. E., W. R. Landsman, and J. R. Wahlen. (1995). Fair value accounting: Effects on banks’ earnings volatility, regulatory capital, and value of contractual cash flows. Journal of Banking and Finance 19: 577–605. Barth, M. E., D. P. Cram, and K. K. Nelson, (2001). Accruals and the prediction of future cash flows. The Accounting Review 76 (January): 27–58. Jane E. Campbell, Heather M. Hermanson, and John P. McAllister, (2002). Obstacles to International Accounting Standards Convergence, The CPA Journal, retrieved as on 8th April 2009 from http://www.nysscpa.org/cpajournal/2002/0502/features/f052002.htm John W. Day, Theme: Accounting for Inventory, retrieved as on 8th April, 2009 from reallifeaccounting.com/pubs/Article_Theme_Accounting_for_Inventory.pdf Read More