IASB improved conceptual framework for financial reporting - Essay Example

?A critical overview of the IASB Improved Conceptual Framework for Financial Reporting Introduction Legal entities of different types of ownership are obliged to comply with regulations in financial reporting, stated in the national accounting standards. But the current process of economic and business globalisation caused the necessity of a common set of standards that could be applied in many countries, providing the consistency and uniformity of accounting and financial reporting throughout the world. Thus, in 2001 the special International Accounting Standards Board (IASB) has been established in the UK in order to design standards, intended to attain a global acceptance. If a company complies with the international accounting standard, it will likely achieve a faithful representation of its financial performance; as well as it will provide the basis for analysis of the company’s position on the global market and further prospects for development of its business. Such information is extremely useful for different stakeholders helping them to make better decisions concerning the company. The “decision-usefulness” approach in accounting has been known even from the 1930-40s. Currently it is laid at the heart of the Conceptual Framework of Financial Reporting, which is being developed by the IASB in collaboration with the US Financial Accounting Standards Board (FASB). This essay is aimed to analyse critically the IASB’s Framework, in particular, regarding the objectives of financial reporting and qualitative characteristics of financial reporting information. The first section of the essay gives a brief overview of development of the Framework since 2006 to the end of 2010. The second section discusses differences between the IASB Framework and the Statement of Principles for Financial Reporting, published in 1999 by the UK Accounting Standards Board (ASB), also only with regard to objectives and qualitative characteristics of information. In conclusion, the main points of the essay are summarised. 1. The development of the IASB Conceptual Framework 1.1 The first version of the Conceptual Framework 2006 In October 2004, at the first meeting within a joint project, the FASB and the IASB have made decision to replace their existing at that time conceptual frameworks with a common standard, which was intended to be “sound, comprehensive, and internally consistent” (IASB, 2006. p.8). Boards were primarily motivated by two objectives – firstly, to provide convergence of existing frameworks, and, secondly, to secure an improvement of the decision-usefulness approach in financial reporting. The fundamental principles of the new conception were adopted from several previous documents. A monograph “A Statement of Basic Accounting Theory”, published in 1966 by the American Accounting Association, emphasised that information ensuing from a process of accounting is more important than the process itself; it defined an accounting as “…identifying, measuring, and communicating economic information to permit informed judgements and decisions by users of the information.” (Lewis & Pendrill, 2004, p. 3) Another important document, which has begun to refocus the accounting policy from stewardship to providing information useful for various stakeholders, is the Trueblood Committee report “Objectives of Financial Statements” (1973). It formulated an objective of financial statements as: “to provide information useful to investors and creditors for predicting, comparing, and evaluating potential cash flows to them in terms of amount, timing, and related uncertainty” (Zeff, 1999, p. 100). In July 2006 the first concept of IASB Framework was published in the form of a Discussion Paper. It defines the objective of financial reporting as “…to provide information that is useful to present and potential investors and creditors and others in making investment, credit, and similar resource allocation decisions” (IASB, 2006, p.18, OB2). This objective could be achieved if provided information would “…help present and potential investors and creditors and others to assess the amounts, timing, and uncertainty of the entity’s future cash inflows and outflows (the entity’s future cash flows). That information is essential in assessing an entity’s ability to generate net cash inflows and thus to provide returns to investors and creditors” (IASB, 2006, p.18, OB3). The shift in objectives turned out the most controversial point in debates around the IASB’s approach. While previous frameworks consider stewardship along with the usefulness in investment decision making as two major objectives of financial reporting, DP claims that the financial reporting information is primarily used for investment decisions: “Users of financial reports who wish to assess how well management has discharged its stewardship responsibilities are generally interested in making resource allocation decisions... Thus, the objective of financial reporting stated in paragraph OB2 encompasses providing information useful in assessing management’s stewardship” (IASB, 2006, p.28, OB28). According to many of opponents, stewardship often is considered more important than investment, as long as a modern private company is controlled by its managers, but owned by its shareholders; so, accounting is viewed by many as a means of control, it reports to owners how managers are good in their duties and how they use a company’s resources (Benston et al, 2007, p.231). BCBS (2006, p.4) asserts that financial statements are prepared primarily as a tool in “assessing performance and the strategy of management, the strength of past earnings performance and the risks undertaken.” One can agree that, in practice, owners (investors) more often need information that helps them to work with management more effectively, rather than to make resources allocation decisions. And stewardship as the essential objective of financial statement provides them with such information, helping to communicate with managers on a constructive basis (Lennard, 2006, p.13). Moreover, aiming to help to forecast future cash flows only, the suggested Framework isn’t able to give users enough information for understanding of real drivers and inherent risks behind these cash flows (Bryer, n.d, p.18). So, financial statements should provide more information at least for assessing future risks, e.g. the discount rate (Hughes et al., 2009, p.1). At the same time, there are a number of commentators who support the IASB’s point of view in regard to the integration of stewardship into the general “decision-usefulness” objective of financial reporting. They argue that such objective should be understood more broadly, as being related to the overall entity’s performance that include a management’s performance as an essential part (ASB, 2007, p.8). Taking into account that the DP focuses financial reporting on usefulness in making resource allocation decisions only, one can realise the IASB’s and its supporters’ concern about a possible risk of mixing financial reporting and corporate governance issues. Thus, striving not to make stewardship a separate objective, the IASB attempts to ensure a feasibility of financial reporting. The diminishing of the role of stewardship entailed changes in many other aspects of the Framework, for example in definition of users of financial reports. DP adheres to an entity perspective, suggesting to consider present and potential investors and creditors (and their advisers) as primary users of general financial reporting, because they are for the most part those who make investment decisions (IASB, 2006, p.22-23, OB12). Such suggestion was controverted by those experts, who believe that the primary users of general financial reports should be owners of enterprises, as “they prepare financial records and statements and engage auditors” (Benston et al, 2007, p.231). This argument (from an proprietary perspective ) seems to be quite sound, taking in account that owners bear all costs, including those related to a lack of knowledge about the company and an uncertainty of other users of information about whether is it worthy to deal with the company; hence, they strive to get comprehensive financial reports. In its turn, DP insists that the entity perspective would be adopted more effectively as the basis for financial reporting, because it allows providing more reliable information for many stakeholders, who have to make resource allocation decisions, but are not able to require needed information from management (IASB, 2006, p.31, BC1.10). The Framework has also introduced innovations in regard to qualitative characteristics of financial information; the most important of them is the replacement of “reliability” of information by its “faithful representation”: “To be useful in making investment, credit, and similar resource allocation decisions, information must be a faithful representation of the real-world economic phenomena that it purports to represent… To be a faithful representation of those economic phenomena, information must be verifiable, neutral, and complete” (IASB, 2006, p.48, QC16). The boards explain that replacement is needed, because the term “reliability” is difficult to explain properly, while “faithful representation” “would more clearly convey the message” (IASB, 2006, p.71, BC2.27). In addition, the change is viewed as an attempt to avoid trade-offs between “relevance” and “reliability” that were possible in previous frameworks. But Whittington (2008, p.146) argues that the possibility for trade-off still remains in the Framework and it becomes even more high. Many other commentators (e.g. Mackintosh, 2006, p.13-15; Miller & Bahnson, 2007, p.47; van Beest & Braam, 2006, p.8) are also concerned at the application of the “faithful representation”, as it seems to be unable to overcome current misunderstanding related to reliability and its attributes. BCBS (2006, p.5) asserts that the “reliability” is more robust concept, which reflects the necessity of “well balanced, objective experience professional judgements and due care for estimates in financial reporting.” 1.2 Development of the Conceptual Framework in 2008-2010 The next versions of the Framework were issued in May 2008 in a form of the Exposure Draft (ED). In relation to the primary user group of financial reporting it introduces a new term “capital providers”: “An entity obtains economic resources from capital providers in exchange for claims on those resources. By virtue of those claims, capital providers have the most critical and immediate need for general purpose financial information about the economic resources of an entity... Capital providers include equity investors, lenders and other creditors, who have common information needs” (IASB, 2008, p.15, OB6). Although the innovation was favoured by the majority of commentators, there were arguments that only equity investors should be the primary user group, because (1) management is accountable primarily to them (Mackintosh, 2008, p.5), and (2) the equity investors bear the highest risks, in comparing to other users (IASB, 2010b, p.8). Focusing on capital providers’ needs, ED re-defines the objective of GPFR as: “to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders and other creditors in making decisions in their capacity as capital providers” (IASB, 2008, p.14, OB2). Thus, the only objective of financial reporting – decision-usefulness – is declared again. However, ED expands the description of the objective significantly, adding a special part dedicated to usefulness of financial reporting in assessing stewardship (IASB, 2008, p.17-18, OB12). This is a clear evidence of the boards’ response onto comments on how stewardship is addressed in DP. Many commentators, including Ernst & Young (2008) and PriceWaterhouseCoopers (2008), point out that ED deals with the issue of stewardship in the proper way, and they are quite satisfied now in this point. At the same time, as Mackintosh (2008, p.3) notes, many other concerns, raised by experts, remain unsolved. Particularly, in relation to qualitative characteristics of information, ED introduces again two main characteristics – relevance and faithful representation, but now it suggests considering them as fundamental characteristics, while four others (comparability, verifiability, timeliness and understandability) as enhancing characteristics. According to the boards, fundamental characteristics work together to make financial information useful for decision making, while enhancing characteristics help to distinguish more useful information from less useful (IASB, 2010a, p.19, QC19). Mackintosh (2008, p.7) asserts that such division is artificial and it may again mislead users as they would think that faithful representation excel such important qualities of information as timeliness or understandability. Ernst & Young (2008, p.5) although generally agree in the necessity of two groups of characteristics, consider understandability to be as much important as faithful representation; hence, they suppose it should be elevated to fundamental characteristics. The final Conceptual Framework document (Chapters 1 and 3) is issued in September 2010. The key concepts of the Framework are practically the same as in ED, although there are certain changes and improvements. In new version a decision-usefulness concept is developed further and represented on a broader scale. The boards define more exactly that financial information about a reporting entity is useful for primary users in “making decisions about providing resources to the entity” (IASB, 2010a, p.9, OB2) and explain that: “…Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit” (IASB, 2010a, p.9, OB2). Moreover, the Introduction gives examples of decisions that users of financial information may have to make, such as “to regulate the activities of entities” or “to assess the stewardship or accountability of management” (IASB, 2010a, p.5). Thus, the boards demonstrate that information in financial statements may be useful for decisions related to various business aspects. There is also a minor change in the qualitative characteristics, the Framework suggests to consider materiality as an aspect of relevance, rather than a constraint as it was in ED. Thus, the Framework claims that there is only cost constraint on useful financial reporting: “Reporting financial information imposes costs, and it is important that those costs are justified by the benefits of reporting that information” ((IASB, 2010a, p.22, QC35). As the document is not meant for discussion and commenting, it is obviously more specific and short, as it contains only essential concepts intended to help users in preparation, presentation and interpretation of financial reports. 2. Comparing and contrasting the IASB Framework and the ASB Statement of Principles. As it was mentioned above, two standard-setting boards work together in order to achieve a consensus in standardisation of financial reporting. It is not an easy task, taking into account the difference in the origins and forms of the UK and US regulatory systems in this area. While the UK system is primarily based on company law, the US system is based on market regulations; thus, the former intends to emphasise stewardship and corporate governance, while the latter – markets and market prices (Bush, 2005, pp.37-38). So, it is not surprising that the resulting documents, aimed to combine two different approaches, are much criticised, especially by the UK experts. In this chapter we compare the final version of the IASB Conceptual Framework (2010) with the ASB Statement of Principles for Financial Reporting (1999), the UK national framework for setting standards in this area. We investigate major differences between two frameworks in regard to the objectives of financial reporting and qualitative characteristics of financial information. Since the ASB Statement (1999) was based on the early IASB Framework (1989), it adopted many of the Framework’s concepts. But recent development of the IASB Framework towards its internationalisation and compatibility with financial reporting standards of other countries (USA, in particular) made these two frameworks much more different than a decade ago. One of the main differences between the frameworks is in their approaches to objectives of financial reporting, and in particular to the “stewardship” objective. The Chapter 1 of the Statement defines clearly two separate objectives of financial reporting – usefulness for stewardship and for decision making: “The objective of financial statements is to provide information about the reporting entity’s financial performance and financial position that is useful to a wide range of users for assessing the stewardship of the entity’s management and for making economic decisions” (ASB, 1999, p.16). The Chapter 1 of the Framework states only the “decision-usefulness” objective: “The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit” (IASB, 2010a, p.9, OB2). Comparing these two objectives, one can see that the ASB proceeds from the assumptions that (1) users of financial reporting need information that helps them to make decisions related not only to providing or allocating resources of a company, as it was stated by the Framework, but to other economic decisions concerning an organisation; (2) information related to decision making is not sufficient for users, they also need the information that helps them to analyse previous transactions and decisions performed by managers of a company. ASB (2007, p.16) points out that the diminishing of a role of stewardship conflicts with the notion of the “general purpose financial reporting” as it focuses only on assessing future cash flows rather than on company performance as a whole. The next important difference between the Chapters 1 of the Statement and the Framework is in their definitions of key users of financial reporting information. While, as we see above, the Statement assumes that financial reporting is useful for a wide range of users, in the next paragraph it clearly defines investors as users having a special significance: “…objective can usually be met by focusing exclusively on the information needs of present and potential investors, the defining class of user” (ASB, 1999, p.16). Moreover, ASB considers that in order to ensure more clarity of the framework, it would be useful to narrow the primary user’s class even more, focusing only upon present shareholders (Mackintosh, 2006, p.12). The Framework, on the contrary, defines a class of primary users of reporting information immediately in OB2, but makes it much broader, including there existing and potential investors, lenders and other creditors (IASB, 2010a, p.9, OB2). As for other users, such as regulators, public, and even managers of a reporting’s entity, the Framework agree with the Statement, that they may find general reporting information useful for their needs. At the same time, the Statement gives a detailed description of different classes of users and their informational needs, focusing particularly on investors; while the Framework gives more general descriptions of its users without much detailing of their needs. In addition, the Framework, as distinct from the Statement, dedicates a separate part of the Chapter 1 to detailed description of information about the financial position of a reporting entity, namely about its economic resources and claims against the entity, as well as about changes in resources and claims. IASB believe that such information would help users to analyse better the company’s financial performance from different perspectives. The Statement also describes information on the financial position and financial performance in the Chapter 1, but discusses this issue mainly from the perspective of investors. The Chapters 3 of the Statement and the Framework relate to qualitative characteristics of financial reporting information. The major difference between them is in their attitude toward the “reliability” concept. The Statement defines four qualitative characteristics of information – relevance, reliability, comparability and understandability, which are considered to be of equal importance (ASB, 1999, p.34). However, the Statement considers relevance and reliability as mutually exclusive concepts, and in a case of choice between them it favours relevance over reliability (ASB, 1999, p.32). Faithful representation is just one of attributes of reliability in the Statement. Just in opposite, the Framework uses faithful representation instead of reliability, defines three attributes of faithful representation – completeness, neutrality and freedom from error (IASB, 2010a, p.18, QC12). Thus, the concept of reliability is completely removed in the Framework. Such drastic changes in qualitative characteristics were not approved by the ASB, who consider the concept “reliability” more appropriate and robust for financial reporting. Mackintosh (2006, p.14), for instance, presumes that the application of the faithful representation may gives managers an opportunity to present unreliable information yet arguing that it is represented faithfully. Moreover, the ASB believe that the faithful representation is ill-defined in the Framework; it causes misunderstanding of the concept, especially outside the US (Mackintosh, 2008, p.8). Another significant difference of Chapter 3 of the Framework is that qualitative characteristics of information are divided there on two groups – fundamental and enhancing ones. One can see that instead of considering qualitative characteristics equally and independently (as it is suggested by the Statement), the Framework sets a certain prescribed order in their application. The ASB regards such distinction between characteristics as artificial and suggests taking all qualitative characteristics as fundamental, because they are equally important (Mackintosh, 2008, p.7). Yet both the Statement and the Framework agree that in order to be included in the financial reports, information should be first of all judged on its relevance. Some minor differences the Statement and the Framework have in relation to the “materiality” concept, which in the Statement is presented as an independent “threshold quality that is demanded of all information given in financial statements” (ASB, 1999, p.42), while in the Framework it is “an entity-specific aspect of relevance” (IASB, 2010a, p.17, QC11). But both frameworks consider materiality as an important characteristic of information about a reporting’s entity, omitting or misstatement of which will likely influence on decisions that users make in regard to the entity on the basis of this information. Thus, one can conclude that there are several significant differences between the objectives of financial reporting and qualitative characteristics of information, presented by the Statement and the Framework. At the same time, the frameworks have common understanding of some aspects. In our opinion, in order to achieve a reciprocal consent and harmonisation in financial reporting standards, standard-setting bodies should take into consideration differences in historical roots, and national, cultural and political peculiarities of economical systems of different countries, to ensure that “General purpose statements wherever required should overlay good systems of statutory / shareholder financial reporting, not replace them, and certainly not drive them out of existence” (Bush, 2005, p.53). Conclusion Bromwich et al. (2010, p.21) assert that improvements in accounting and financial reporting standards are often driven by understanding that current set of conventions became out-of-date and is increasingly losing its practical usefulness. New regulations appear; they are often based upon old concepts, redefining and reconstructing them in accordance with new needs and requirements. This paper explores the process of development of the IASB’s Conceptual Framework, as a response of standard-setting bodies on recently emerging requirements to provide an internationally-accepted standard in financial reporting. Today it is evidently that joint efforts of the IASB and the FASB, two recognised leaders in accounting standard-setting, help to facilitate progress towards the convergence of different national accounting standards within the document. But, such convergence is not easy to achieve, firstly, because of differences between national and the IASB’s standards, and, secondly, because the Conceptual Framework is hitherto in the process of critical discussion and improvement. Being based on the concept of “decision-usefulness”, the Framework introduces a multi-stakeholder approach, focusing on an investment role of accounting, rather than on specific needs of shareholders. 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