Key Features of the Financial Report - Essay Example

?2.0 Definition A conceptual framework is defined as “a coherent system of inter-related objectives and fundamentals that should lead to consistent standards that prescribe the nature, function and limits of financial accounting and financial statements.” (ACCA, 2011) It is a statement of generally accepted theoretical principles, which form a basis and reference for financial reporting. According to the framework, the objective of financial statement is to provide information in regards to the financial position, performance and changes in financial position of an entity which are is useful to a wide range of users in making economic decision. Therefore, it is important that users are able to distinguish the financial statements clearly from other related information published in the annual report as IASs or IFRs only apply to the financial statement. 3.0 Qualitative Characteristics The framework states: “Qualitative characteristics are the attributes that make the information provided in financial statement useful to users”. The statement of principles identifies five principal qualitative characteristics consist of understandability, relevance, reliability, materiality, and comparability elaborated as below. 3.1 Understandability Understandability refers to the way in which information is presented in the financial statements and the capabilities of the users to utilize the financial information. However, assumption is made whereby users are equip with basic business, economic and accounting knowledge and thus be able to interpret the information accurately. All the relevant information is required to be reflected in the financial statement disregards of its complexity and the fear that misunderstanding would arise due to the complexity of the issue. Additionally, an organized presentation of financial information would enhance the understandability of the users. 3.2 Relevance Information is said to be relevant if it has the ability to influence the economic decisions of the users and is provided in time to influence those decisions. Relevant information assists users in analyzing the past trends, present situation and predicts the future prospect based on the past analysis. Besides that, it allows the users to enhance their knowledge on the firm by confirming or correcting their past evaluations. The ratios calculated based on the financial statement provides an insight on the financial performance of the firm and areas which are of high interest to the owner such as dividend payout, price earnings ratio and earnings per share. Moreover, it can be used to evaluate and predict its future outlook and indicate the firm’s investment attractiveness. 3.3 Materiality The relevance of information is affected by its nature and materiality. Information is considered to be material if its omission or misstatement would significantly affect the economic decisions of the users, taken on the basis of financial statement. Items which are substantial in terms of size and nature such as auditor fees and director fees are essential to be disclosed in the financial statement. However, materiality is not a primary qualitative characteristic itself as it is merely a threshold or cut-off point. 3.4 Reliability Information must also be trusty and possess faithful representation. Information is reliable when it is free from material errors and bias and can be depended upon by users to represent the economic conditions that it purports to represent or could reasonably be expected to represent. Besides that, it contains the characteristics of being verifiable and neutral. Information which is relevant but unreliable may be misleading and cause disputes or claim for damages in a legal action. 3.4.1 Faithful Presentation Information must represent faithfully the transactions it purports to represent in order to be reliable. There is a risk that this may not be the case, not due to bias, but due to the inherent difficulties in identifying the transactions or deciding on an appropriate method of measurement or presentation. Thus, it is advised that in the case where measurement of the financial effects of an item is uncertain, entities should not recognize such as an item, for example, an internally generated goodwill. 3.5 Comparability In terms of comparability, accounting information must be reported in a similar manner so that users are able to compare the entity’s annual financial statements to identify its past trends or with different enterprises to evaluate their relative financial position, performance and changes in financial position. Therefore, it is important that accounting treatment for a line item within the financial statement and across industry is consistent. The disclosure of accounting policies is particularly important as it allows users to differentiate the accounting policies adopted by the entities and make valid comparisons by adjusting the differences before making comparisons. In addition, comparability is dissimilar with uniformity. Entities are allowed to change the existing policies if they are found to be inappropriate. However, it must restate the comparative results so that it is comparable to the current year results. 4.0 True and fair view ( fair presentation) According to the conceptual framework, the application of the principal ‘qualitative’ characteristics mentioned above and the use of appropriate accounting standards would result in a true and fair financial statement. It is required by the national legislation for entities to produce a true and fair financial statement representing its financial performance during the year and the financial position as at financial year end. The term “true and fair view” and “present fairly” in all material aspects are not defined in the accounting or auditing standards. Hence, practitioners may depart from any of the provisions of accounting standards if the adoption would impair the true and fair view of the financial statement. This is commonly referred as the “true and fair override”. It has been treated as a critical loophole in the law employed by different countries and has been the cause of much arguments and dissatisfactions within the accounting profession. In conclusion, true and fair view has no absolute definition but rather a legal concept which evolves over time and changes made in generally accepted accounting practice (GAAP) and in extreme cases, are decided by the courts. 5.0 International Financial Reporting Standard (IFRS) & International Accounting Standards (IASs) IFRS are principles-based Standards, Interpretations and Framework (1989) adopted by the International Accounting Standards Board (IASB). Many of the standards forming part of the IFRS are known by its older name - International Accounting Standards (IAS). IAS was issued between 1973 and 2001 by the Board of the International Accounting Standards Committee (IASC). With effective from 1 April 2001, the new IASB took over IASC’s responsibility in setting the International Accounting Standards. During its first meeting, the new Board decided to adopt the existing IAS and SICs while the new standards developed by the IASB are named as IFRS. IFRSs are developed through a formal system of due process and broad international consultation involving accountants, financial analysts and other users and regulatory bodies from worldwide. The framework intend to avoid the fire-fighting approach which formed the basis of development of accounting standards in the past, but instead to develop an underlying philosophy as the basis for consistent accounting principles so that each standard fits into the entire framework. The research began with an analysis on the fundamental objectives of accounting and their relationship to the information needs of accounts users. The framework has so far gone beyond the requirements of the existing accounting standards and defines the accounting treatment and nature of assets, liabilities, income and expenditure. 6.0 Accounting treatment Many of the old IASs permitted two accounting treatments for a particular transaction or event where a benchmark treatment is provided with an alternative treatment. This is no longer the case under the new framework. The last standard which has an alternative treatment - IAS 23 has also been revised to remove the alternative treatment. The benchmark treatment of IAS 23 states that all borrowing costs should be expensed off in the Income Statement in the period in which they are incurred. The allowed alternative treatment on the other hand specifies that borrowing costs in relation to the acquisition, construction and production of a qualifying asset should be capitalised and where the allowed alternative is adopted, that treatment should be applied consistently. Besides that, if the funds are borrowed specifically, the costs which are eligible to be capitalised consist of the actual costs incurred less any income earned on the temporary investment of such borrowings. However, if the funds are part of a general pool, the eligible capitalised amount is determined by applying a capitalisation rate to the expenditure on that asset where capitalisation rate is the weighted average of the borrowing costs applicable to the general pool. Capitalisation should commence when expenditures and borrowing costs are incurred on activities which are necessary to prepare the asset for its intended use or sale and ceased during periods when the active development is being interrupted. Besides that, capitalisation should also be suspended when all the activities necessary to prepare the asset for its intended use or sale are being completed substantially. Activities are regarded as substantially complete when there are only minor outstanding modifications. In the case where construction is completed in stages, the borrowing cost attributable to the parts which have been substantially completed is to be ceased disregards of the on-going construction as a whole. In the past, the IASB offered an alternative in the application of particular standards. The preferred choice is labeled as the benchmark treatment while the optional treatment is called allowed alternative treatment. Following either one of the treatments are still considered as in comply with the standard. However, as the benchmark was a more rigorous treatment, an entity could change from an allowed alternative treatment to benchmark treatment but not otherwise. This is elaborated further as follow: “IAS 22 provides a benchmark treatment and an allowed alternative treatment in measuring the acquired assets and liabilities. Under the benchmark treatment, the assets and liabilities are measured at the aggregate of the fair value of the identifiable assets and liabilities acquired to the extent of the acquirer's interest obtained, and the minority's proportion of the pre-acquisition carrying amounts of the assets and liabilities. The allowed alternative treatment however signifies that assets and liabilities should be measured at their fair values as at the date of acquisition with the minority's interest being stated at its proportion of the fair value of the assets and liabilities. In April 2001, the International Accounting Standards Board announced its intention to launch a project to 'improve' the IASC Standards. The Improvements Project which was completed by 31 March 2004 removed some of the alternative accounting treatments and where an IAS retains an alternative treatment, the references of 'benchmark treatment' and 'allowed alternative treatment' has changed to descriptive references such as 'cost model' and 'revaluation model'. The Improvements Project standards are effective for annual periods beginning on or after 1 January 2005”. Sandy (2007) 7.0 Creative accounting Creative accounting is also referred as income smoothing, earnings management, earnings smoothing, financial engineering and cosmetic accounting. The preferred term in the USA, and consequently in most of the literature on the subject is called ‘earnings management’ but in Europe, the preferred term is ‘creative accounting’. Thus, the term ‘creative accounting’ would be used in the rest of this paper. It is recognised that some accounting manipulation involves primarily balance sheet rather than earnings management. Definitions of creative accounting vary as follows: ‘Is the deliberate dampening of fluctuations about “some level of earnings considered to be normal for the firm”’. (Barnea et al. 1976) ‘Is any action on the part of management which affects reported income and which provides no true economic advantage to the organization and may in fact, in the long-term, be detrimental’. (Merchant and Rockness, 1994) ‘Involves the repetitive selection of accounting measurement or reporting rules in a particular pattern, the effect of which is to report a stream of income with a smaller variation from trend than would otherwise have appeared’.(Copeland, 1968) Schipper (1989) observes that ‘creative accounting’ can be equated with ‘disclosure management’, ‘in the sense of a purposeful intervention in the financial reporting process’. The IASB has introduced the principle of “substance over form” in the Framework in order to deal with creative accounting and to avoid management adopting inappropriate accounting policies to manipulate the financial statement into a favorable manner. The phrase “substance over form” implies that “Transaction and other events should be accounted for and presented in accordance with their substance and financial reality and not merely with their legal form”. This is an important concept used to determine whether an item should be recognized and shown in the financial statement preventing off balance sheet transactions. Creative accounting which involves manipulation of financial statement for a desired result can takes in many forms. Off-balance sheet event is a major type of creative accounting and probably has the most serious implications. Creative accounting is rarely used to conduct personal fraud but has an indication on the share price of the Company. This is because brokers and analysts recommendations which are based on the financial statements are perceived to be an indication of the future outlook of the Company and have major impact on the share price. A sharp fall in the share price caused by the unfavorable result shown in the financial statement might pose a takeover risk to the Company. Consequently, companies will attempt to produce results which are up to the market expectations. The companies aim to achieve the targeted results expected by the shareholders and produce ratios which portray a healthy outlook of the Company. The methods available for creative accounting and the determination and imagination of those who which to perpetrate such acts are endless caused by the loopholes in the accounting standards or law. Thus, regulators and standard setters have changed the development approach from detailed rules to having general principles. The following are some of the examples of creative accounting: 1. Manipulation of revenue with inappropriate cut-off period. For instance a company may overstate its revenue by recognizing post period transactions, altering the invoices issued after the accounting year end. 2. Manipulation of accruals, prepayment and contingencies as the accounting treatment involves high degree of judgment and subjectivity, in particular on contingencies. For example, it is difficult to estimate the contingent liability or possible loss in the case of impending legal action especially when the lawyer is unable to indicate the likelihood of success or failure of the case. In such situation, the company would only be required to disclose the circumstances indicating the possibility of such a liability even though the eventual costs incurred may be substantial. 8.0 List of reference 1. Sandy (2007) http://answers.yahoo.com/question/index?qid=20080725013722AAy5sks –last view 24 April 2011 2. http://www.econ.upf.edu/docs/papers/downloads/749.pdf - last view 24 April 2011 3. http://www2.accaglobal.com/archive/sa_oldarticles/13202 - last view 9 May 2011 Read More