Contribution of relevance and reliability on financial reporting - Essay Example

? Conceptual Framework Table of Contents 2 Chapter Introduction 3 Chapter 2: Theory 3 Purpose of Financial Reporting 3 Relevance and Reliability 5Chapter 3: Practice 6 Contribution of relevance and reliability on financial reporting 6 Chapter 4: The application of theory to practice 8 Dilemma of financial reporting in practice 8 Application of different valuation methods 10 Chapter 5: Recommendations and Conclusions 12 Works Cited 13 Chapter 1: Introduction Relevance and reliability are two qualitative characteristics of any information that distinguish more useful information from the inferior or less useful information. These two qualities are highly related to financial information reported and published by companies. Main objective of accounting policy is to produce fair valued accounting information that is highly reliable and relevant to the purpose and objectives of financials statement. Financial statements are the most important components of annual report that all public limited companies publish each year for the stakeholders of the company. The financial statements need to be the fair and ethical representation of financial details of all activities performed by the companies. Financial information is responsible for financial decision making by the investors, creditors, suppliers etc. Most important is investment decision making by the investors. So, relevance and reliability need to be two most important characteristics of financial statements of any organizations. These determine the quality of financial reporting. Main objectives of financial statements are to provide fairly reported and audited financial information to the shareholders of the organizations. So, users of financial statements consider it as reliable and relevant sources for taking decision for any financial purposes like investment, credit, supply etc. So, being a highly responsible for financial decision making, financial statements need to be relevant and reliable. Chapter 2: Theory Purpose of Financial Reporting Financial reporting poses two major purposes, internal and external. Most important is external purpose of financial reporting which is responsible for valuable financial decision making by the investors, shareholders, creditors, suppliers and credit rating analysis by credit rating agencies, government and regulatory bodies like taxation department. So, all these external stakeholders of a company are highly reliable on its financial reporting which truly represents the company’s actual value and performance. Internal purpose of financial reporting is to retain standardized record of financial activities done by the company in a regular interval of time i.e. quarterly, half yearly and yearly. It helps the organizations to evaluate its performance at the end of each financial year and also the end of each quarter of a financial year (FASB, p.15). Companies develop future business strategies based on the past performance of the company which can only be possible to evaluate from the financial reporting of past quarter or past financial years. Companies change strategies and planning for implementing new activities for next quarter and next financial years and they also develop budgeting for next financial years by analyzing previous years projection verses actual results. All these are possible because of maintaining fair valued financial reporting. (Narotama University, p.135). Financial statements published by the companies provide valuable information to the investors, shareholders, creditors, suppliers so that they can track the value with respect to time and uncertainty of a business entity. Future performance of a firm can be assessed by the future cash inflow and cash outflow into a business. The elements of financial statements like income statement, balance sheet and cash flow are very important to evaluate company’s performance and financial health. Investors are the most important users of financial statements. From financial statements, they assess the stewardship of management to an organization in terms of safeguarding valuable resources, proper allocation and effi8cient use of resources or assets and overall profitability of an organization. They take decision about need for new management. Most importantly, they take investment decision like whether to buy, sell or hold their stakes of the company based on the current and future performance and possible profitability of the organization. Lenders evaluate financial information for evaluation of creditworthiness of a firm. They decide whether to lend or not based on the creditworthiness of a company. Suppliers also need financial information to evaluate average payable time and ability to pay short term liabilities without depending on inventories. They always desire stability of a company to supply raw materials. Financial statements represent three main aspects of a business (IFAC, p.16). The main factor is the business is profitable or not and the amount of profit and loss and also past long term duration of profit and loss. Secondly, quality assets the company has and efficiency of asset management like how much assets the company has to cover its liabilities. Third, financial statements provide information about source of capital of a business and efficiency of the business to use that capital to generate substantial return. Companies assumes that users of financial statements are knowledgeable enough assess evaluate financial information of their different needs. This is the main purpose of financial reporting to fulfillment the needs of users of financial statements. Relevance and Reliability Two most important qualities of any information are relevance and reliability. These are two important characteristics of financial reporting. Relevance means any information backed by particular facts and data satisfy its purpose successfully. Decision maker take into consideration of information for making valuable decision by considering the information is relevant to the purpose of decision making. Time is most important factor to make information relevant for its purpose. Any information may be relevant for a specific time period and the same may not be relevant in other time when necessity of this information is very less. So, relevance is most important quality that needs to be emphasized in all accounting framework and financial reporting. It is one of the most important characteristics of financial information which is responsible high valued financial decision made by organization and its different stakeholders (Rutherford, p.50). Reliability is another important characteristic of any information. It is a quality of information that ensures that information is free from any kind of biasness and error. Fro, financial information, reliability represents that financial statements is made by faithful representation of all financial information of a company. Reliability of financial information consists of three main sub factors that are verifiability, trusted and faithful. To make financial information faithful, the companies make an agreement between the company and the users of financial information that users can make any kind financial decision based on the information provided by them and information is truly representation of company’s financial position and it can be used measure qualitative performance of the company. Verifiability of financial information ensures that the information is audited by reputed authority. For example, provisions for bad debts are collected from debtors after deducting the receivables amount. Now, if provision is very low then a huge amount might not be collected from the bad debtors. Therefore, this value does not provide reliable information of a company because it does not fairly represents the receivables amount (Walton, & Aerts, p.12). Relevance and reliability of financial reporting are also important for internal usage of past financial information. Management and preparers of financial statements need historical financial information of the company to show the growth or decline of the company in terms of profitability and many other parameters of performance of a company. Recording of accounting transactions in daily basis helps the auditors to evaluate the reliability factor of financial statements. Verifiability of financial statements by authorized auditors enhances the quality of that information in terms of reliability of the same to fulfill its purpose. Important users of financial statements like the investors and creditors always expect recording of more representative fair value of financial activities. According GAAP principle, all assets of a company should be fairly valued based on the current market price of those assets and the investors and the creditors are also interested current market price of the assets of a company to evaluate financial strength of the company (Nicholson, p.25). Chapter 3: Practice Contribution of relevance and reliability on financial reporting Relevance and reliability are two different but essential quality of financial reporting that enhance the quality of financial statements. The users of financial statements always desire relevant and reliable financial information for making their valuable financial especially investment demission making. These two qualities are not interdependent that means if one is present another might not present in specific information but if both of these present in a financial reporting then it fulfill its purpose (IASB & IASCF, p.88). Financial decision makers need information relevant for analysis and source of information needs to be reliable. For example if an investment is done on shares the n value of the investment will be considered by the last closing value of that share price. Land is one of the tough assets to evaluate as no indices are there for land prices. So, it is highly subjective to evaluate land price. Though past recorded value for taken into consideration for current decision making but it satisfies both the quality of financial reporting that is relevance and reliability. Therefore, relevance and reliability factors can be maintained by implementing fair value accounting (Belkaoui, p.185). Preparers of financial reporting practice various accruals and deferral methods like prepayments. These produce approximate values which might be not totally reliable. For historical cost recording, the preparers need to concern about not to make financial reporting by estimation or future projections. Financial statements are representation of sales, purchase etc and many other business activities for specific period of time. Companies report financial values in exact numbers not fraction numbers. So, a difference between fair value and historical value based measurement of assets. An asset may have zero book value but it might have 1000 as its fair value. Reporting of historical cost in financial reporting has major influence on relevance and reliability factor. Time is most important factor for relevance of any information. Financial information becomes outdated as time goes and investors considers past financial information less relevant for current investment decision making (Britton, & Alexander, p.147). For recording fair value accounting, price is estimated for valuation assets at market referenced price. But some typical assets might not have any current market value. So, these assets are measured only based on historical value. This type of financial reporting is not reliable for financial decision making. Mistakes are made by the investors while considering these types of assets and it results inefficient investment decision. Many companies practice unethical business practice by increasing the fair value of the firm to enhance current value of the firms. Therefore, fair value measurement has introduced high volatility in financial reporting. So, relevance and reliability of financial reporting needs very strict and faithful reporting of financial values. These qualities of financial reporting minimizes the loss of investors, increase the confidence of creditors, suppliers and even customers towards a company. It also represents ethical business practice of firms that is one of the important corporate responsibilities of any business. Chapter 4: The application of theory to practice Dilemma of financial reporting in practice The dilemmas faced by the preparers during the preparation of the financial report are the decision related to the incentives of the firm when the company is in two minds whether to adopt the policy or not. The adoption of the regulatory challenges also pose problem for the preparation of the financial report of the organization. The challenges also faced in terms of cultural barriers during their adaptation and implementation which acts as barriers in terms of the relative cost of compliance for both medium and small scale entities and accounting firms. The complexity and the structure of the organization in relation to the IFRS regulations adopted by the organization and training of the professional accountants under the international standards may pose as a challenge in the process of preparing the financial reporting of the organization (Rogers 74). However, the contingent account of the firm may or may not be disclosed depending on the probability of its occurrence. This leads to challenges which are faced from the adaptation and implementation of IFRS as finding the actual meaning of the international convergence is quite difficult. Translation of the International Standards along with frequency, volume and complexity of changes to the international standards and potential shortfall of knowledge are also the challenges faced by the organizations. The method under which the calculations are made may be on the basis of different financial principals. This prevents the firm from comparing its performance to other companies within the same industry. The preparers may face challenge in terms in the number of financial statements from being precise (Porter & Norton 29). Moreover, the accounts for the bad debt or provision for doubtful debt may increase the liability of the company which may turn out to be a superficial accounting. The historical data on which the financial records are based cannot be dependent for projecting the future cost of the company. This can put the preparers of the financial report in a dilemma. The adjustments that occur at the end of the year may put forth great challenge for the preparers of the financial report of the company (Wong 1-30). Thus the concept of relevance and reliability is an essential element to overcome the shortcomings faced by the preparers of the organization. The challenge for the preparers is that the data gathered should be both reliable and relevant to the organizations business policy thus adopted. However the methods through which the shortcomings of financial reporting can be overcome are successful adaptation of the international standards which is dependent on the development of high quality standards and integrity in the application of the international standards. Auditors, users and preparers of financial statements should also support and encourage compliance with the substance and form of the international standards. International standards should be adopted as well as implemented both at the national and international levels. At the national level, it is essential that the regulators, government and national setters place international convergence as a priority on their agendas. At the international level, the international standard setters should also establish procedures and processes that facilitate the national input and lead towards development of globally accepted high quality standards. Development of the formal translation plan, including professional accountant in the translation team needs to be established. Moreover, ensuring consistent use of terminology with proper scope of translation in the first instance; obtaining an input of translators of the international standards in other countries as well. National professional bodies providing training to its members through seminars is highly recommended; accounting firms and large entities offering compulsory training to their staff and establishment of organizing forums where the organizations can discuss challenges and solutions through the implementation of specific IFRS. Better access to global capital markets along with elimination of multiple reporting should be improvised. Clear understanding of requirements, avoiding cluttered information and including of comparable quantitative information rather than bland statements is the need of the hour. However, capturing and identifying relevant information, collection of record in a systematic manner and analyzing and interpreting the information thus collected should be emphasized on. Reporting the information in a manner in which it suits the needs of the users keeping within the regulations thus laid in the IFRS is very important. Time orientation should be maintained for the application of relevance and reliability of the data. Separation of the public reporting from the corporate income taxation, so that the tax objectives do not get distort the available financial information and effective and independent legal system for the organization for the detection of fraud , if any (Chen 1-2). Therefore, by adopting the measures laid above the shortcoming of the financial reporting related to the relevance and reliability of the information can be overcome. It is very important to overcome the challenges of financial reporting by the preparers because based on the concept of reliability the stakeholders of the organization will take decision accordingly. Moreover, the relevance of the accounting information binds the stakeholders to the company on the basis that the source from where the information has been drawn is relevant to the principle of accounting thus adapted by the organization. But achieving both reliabilities and relevance of the information is usually very difficult. Hence, a choice between the two has to be made warding off the other. Application of different valuation methods As the market is mostly dynamic and volatile in nature people are mainly interested as to the asset of the company is worth investing in. Adaptation of the fair value measurements provides more transparency than the historical cost based measurements. The application of the fair value measurements in all the financial instruments of an organization would have led to the stakeholders of the organization to have greater regulatory and market discipline at the same time avoid losses incurred by taxpayers and investors during the economic downturn (Damodaran 6). Methods that are incorporated in tandem with the concept of relevance and reliability are valuation models related to goodwill under which comes the average profit method, super profit method, capitalization method and annuity method; valuation models of patents under which comes the cost based methods, market based methods, income based method, discounted cash flow method (discrete time period type analysis and continuous time option valuation method), DTA based method and option pricing theory method. Under the super profit method excess provision for the interest of the goodwill is computed. In capitalization method the buyer is ready to purchase an ongoing company at the capitalized value. Annuity method boost the super profit method by calculating the same over the years during which the super profit is expected to earn by the company. However, in the cost based method of accounting under the valuation models of the patent helps in taking rational decision for the organization. In the market based method of accounting the valuation of the assets of the organization is done based on the comparable assets which have been traded between parties at arm’s length in an active market. On the other hand, income based pricing helps in involving element of forecasting the future cash flows. In case of conventional discounted cash flow method that one begins to get valuation methods using projections of future cash flows to value patents. To bring about the flexibility in accounting DTA method is adopted by organizations. To overcome the factors of risk the valuation model related to the option pricing theory was adopted. The discrete time binomial model was used to solve the problems concerning changing discounting rate which could not be solved otherwise by the DCF/DTA models (Srivastava 9-12). Accrual and deferral methods are being used in the preparation of the financial statement of the organizations. The main purpose for the adoption of the accrual and deferral models is the measurement of the earnings yielded by the organization under the legislation and rules led down by FASB. The assumptions under accrual and deferral models are the accruals of the organizations over which the head of the authority can enjoy some control to improve the earnings of the organization. The advantage of this method is to enhance the quality of the financial report of the firm based on the information acquired by the company in tandem with the concept of relevance and reliability. The quality of the information thus obtained from the organization is utilized in the most efficient way by the adoption of the value relevance method. In value relevance method the focus is mainly on the relation between the accounting figures of the company and the stock market variations. Thus adaptation of proper framework helps in the applicability of both the concept of reliability and relevance as far as the financial reporting of the organization is concerned. The application of relevance and reliability during the financial reporting of the organization under the ever changing economic scenario helps gain confidence of all the stakeholders of the organization. Moreover, the financial report thus issued by the organization is nearing accuracy. However, the company which applies only one concept during the preparation of the financial reporting of the organization lacks the touch of efficiency that can otherwise yield more profitable venture for the organization (Cho, Kim & Lim 1-9). Chapter 5: Recommendations and Conclusions When the financial accounting is done the application of both the concepts, relevance and reliability are taken into account. This is done because these are the two concepts of finance from the qualitative perspective. As the main objective of the application of the fair value system of accounting because it renders higher relevance and reliability of the data thus recorded. However, the two purposes are served by the application of the relevance and the reliability of data. Time being the other important factor should also be taken into consideration. For if the financial reporting id done based on the financial books of accounting in which the transactions are recorded at the time of its occurrence then the discrepancies caused will be minimized. However, under the present economic scenario the application of both the concepts of relevance and reliability is quite not possible. Thus necessary measures needs to be adopted so as to overcome the dilemmas (Rutherford 50). The economy at present is turmoil in nature which is why the fair value measurement of the financial statements is more essential for the organization. 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