IASBs Framework for the Preparation and Presentation of Financial Statements - Research Paper Example

 International Financial Report Introduction In order to achieve the objectives of financial reporting in accordance with framework prescribed by IASB for financial statements, the information contained in the financial statements should be not only be useful but also faithful representations of events and transactions covered in the financial statements.. Certain characteristics that add to the usefulness of the information are of the primary qualitative nature stated in the framework. These qualitative characteristics are identified in the IASB’s Framework for the preparation and presentation of financial statements as the characteristics of understandability, relevance, reliability, and comparability. Understandability of information provided in the financial statements implies that presentation of information meets the needs of users of financial statements by exercising reasonable knowledge of business, economic, and accounting activities. The characteristic of relevance includes the predicable value, feedback value, and timeliness. The information must also be reliable in order to be useful. The characteristic of reliability includes the ingredients of representational faithfulness, verifiability, and neutrality. The virtue or the characteristic of comparability indicates that the entity is applying principles that are comparable to those applied by similar entities in similar circumstances and also there is consistency in application by the entity itself.. It is believed that these characteristics are encouraged in standards framed and issued under the stewardship of International Accounting Standards Board (IASB). The standards covered in this study are IAS 16, IAS 17, IAS 23, IAS 36, and IAS 37. IAS 16 deals with matters relating to Property, plants, and equipments; IAS 17 relates to issues of leases; IAS 23 provides guidance for dealing with borrowing costs; IAS 36 with impairment of assets; and IAS 37 is attached with the regulations of provisions, contingent liabilities, and contingent assets. The purpose of this write up is to explore whether basic characteristics of understandability, relevance, reliability, and comparability are encouraged by the regulations contained in IASs16,17, 23, 36, and 37, and accordingly the relevant international accounting standards are scrutinized hereunder. IAS 16- Property, Plant, and Equipment (PPE) The objective of IAS 16 is to regulate and prescribe the accounting treatment of property, plant, and equipment so that the users of financial statements get the required information. With regard to initial measurement of PPE the standard prescribes two models, cost model and revaluation model. Whatever model is applied it has be used consistently over the same class of assets. Consistency indicates that the entity is applying the same principles from one period to the next. In this way the principle of consistency compliments the virtue of comparability. This is because comparisons can be made only when subject matters get the similar treatments. That is why IAS 16 seeks continuity in using the same model in recognition of PPE year after year. Paragraph 29 of IAS 16 insists that ‘accounting policy that a company selects – cost model or revaluation model – has to applied to an entire asset class of property, plant, and equipment; a company’s assets of similar nature and use in its operations form an asset class. Land; land and buildings; furniture and fixtures; and office equipments are examples of separate classes.’(Maria Davis, page 59)i The framework provides that an asset should be recognized only when its costs or value can be measured reliably. The concept of reliability brings alongside the virtue of faithful representation of facts. The framework provides that ‘reliability involves providing information that represents transactions or events faithfully in accordance with their substance and economic reality rather than legal form. To be reliable, information must be neutral (unbiased), prepared with prudence (conservatism), and complete, taking into account the principles of materiality and costs/ benefits.’(IASB Framework)ii. That is the reason IAS 16 does not allow initial recognition of PPE at fair value except in few limited cases. IAS 16 advocates that historical costs at the time of initial measurement Basically IAS 16 conducts the accounting treatment of PPE under different circumstances and in doing so it strictly seeks to treat any expenditure as an asset only in terms of framework of preparation and presentation of financial statements. ‘The standard notes that the general definition and definition criteria for an asset given in the Framework for the Preparation and Presentation of Financial Statements must be satisfied before IAS 16 applies. Subject to that IAS 16 applies to accounting for all property, plant, and equipment except when another IAS requires or permits a different treatment.’(David Alexander and Others, page 266)iii Treatment of assets under fair value model after the first recognition of assets is an effort to add relevancy character to already recognized assets. Relevancy should have a feedback value and fair value model provides this attribute to the presentation of assets in the financial statements. Though IAS 16 has framed rules adhering to the framework regulations but there is every possibility of management doing a distorting job. ‘The task of determining the fair value is delegated to management, with oversight by the firm’s auditors, potentially leaving opportunities for management bias in valuing assets and for legitimate difference of opinion between managers and analysis over asset valuations. In most cases, management bias will lead to overstated assets since managers will prefer not to recognize impairment or prefer to overstate nonamortized goodwill in business combinations. However managers can also bias asset values downward reducing future expenses and increasing future earnings.’(Krishna G. Palepu and others, page 132)iv The virtue of verifiability and neutrality are main ingredients of reliability. If an assertion is reliable it is natural that such reliability is verifiable as well. IAS 16 has provided the option of revaluation model of accounting after initial recognition. ‘The option to revalue a class of property, plant, and equipment has been restricted to situations where fair value can be measured reliably.’(Catherine Gowthrope, page 20)v Being reliable such fair value will also possess the qualities of verification as the assessment of fair value has to be based on information or other material gathered by the entity. Above analysis of IAS 16 reveals that accounting of PPE has been regulated by the standard following the characteristics stated in the framework issued by IASB. IAS 17- Leases The IAS 17 prescribes appropriate accounting policies and procedures for lessor and lessee. In doing so the standard has made the necessary distinction between operating and finance leases. In describing such distinction IAS 17 has kept the qualities or attributes stated in framework alive in the accounting presentation of different types of leases, though certain controversies arose in its accounting treatment of leases. As per IAS 17 a leases may be operating leases in which the lessor is receiving rent payments that will be recognized as revenue over the term of the lease and the lessee is making the payments to be recognized as expense. In some cases, however, a lease transfers substantially all the rights and risks of ownership to the lessee in which the lessee records the lease as a capital lease and the lessor records the lease as a sale type or direct financing lease. In other words the surrounding facts or the circumstances (substance of the transaction) define the type of lease to be accounted for by lessor and lessee and that is how the characteristics of understandability are inscribed into the accounting for leases. Despite this clarification of classification of the leases as finance and operating leases there have been controversies surrounding IAS 17 for characteristically different from what has been prescribed in paragraph 35 of the framework that states that ‘if information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form.’ The fact is that ‘the correct accounting treatment of borrowing transactions, based on its substance, was to include in the lessee’s balance sheet a liability representing the obligation to meet the lease payment, and the correct accounting treatment for the asset acquisition transaction, based on its substance, was to include an asset representing the asset supplied under the lease. IAS 17, para 10, states categorically that ‘whether a lease is finance lease or an operating lease depends upon the substance of the transaction rather than form of the contract.’(Jamie Elliot, page 274)vi Accordingly it can said that classification of leases as finance and operating as described under IAS is actually a faithful representation of facts. IAS 23- Borrowing Costs Borrowing cost include the finance expenditure incurred in relation to obtaining and servicing the borrowings. IAS 23 provides regulations for accounting treatment of borrowing costs. “The benchmark treatment is that the borrowing costs should be expensed in the period in which they are incurred. The allowed alternative treatment is that the borrowing costs in relation to the acquisition, construction, and production of a qualifying asset should be treated as part of cost of the relevant assets.’(Deloitte, IAS 23- Borrowing costs)vii Certain quarters had apprehensions about capitalization of borrowing costs that raised the questions about relevancy of the provisions of IAS 23 seeking such capitalization of borrowing costs. EFRAG while commenting on exposure draft of IAS 23 expressed that ‘the conceptual justification of capitalizing as opposed to expensing financial acquisition costs is not given the exposure draft even though the proposed amendment will result in a reversal of current practice for many constituents…….The elimination of expensing option will bring about a reversal of current practice in many cases although no technical arguments have been provided to justify this change. Currently IFRS1 does not encourage capitalization of borrowing costs as no exception to full retrospective application has been allowed to the first time adopters of IFRS. So, groups that had a past practice of capitalizing borrowing cost according to local principles that are not fully compliant with IAS 23 have been, in most cases, obliged to expense borrowing costs due to practical difficulties of achieving full retrospective capitalization under the standard. The ED recognizes the practical difficulties of full retrospective application and proposes transitional application.’(Antoine Bracchi, 22 Sep.2006)viii Another critical feature of IAS 23, when compared to conceptual framework of IASB, is that it lacks representational faithfulness. The borrowings for a project may be from a specifically assigned fund or from general borrowings. Normal capitalization of interest on borrowing is in conformity with the provisions of IAS 23, but further elaborations and clarification are required so far as borrowings are from general fund. As per Charlotte J. Wright and Rebecca A. Gallun (page 209)ix ‘if from general borrowings, the capitalized interest should be based on the weighted average cost of the general borrowings outstanding during the period. Capitalization is to begin when interest and expenditure are being incurred and construction of the asset is in progress. Capitalization is to be suspended if construction is suspended for an extended period, and should cease when substantially all activities are complete.’ The interest on borrowings not used for the project but obtained from general fund should not be capitalized to the project. As the standard does not clarify this aspect, it can be stated that standard does not provide faithful representations. However, IAS 23 has not taken care of the virtue of consistency in the sprit of framework envisaged by IASB. It is true that an entity may decide to opt in favour of capitalization of borrowing costs, but this option of capitalization should be followed in respect of all borrowings being utilized for acquisition, construction or production of qualifying assets. It is not enough that option to capitalize the borrowing costs should only be in respect of specific borrowing. It should be made applicable to all types of borrowing utilized for the qualifying assets. ‘Where an enterprise adopts the allowed alternative, the treatment should be applied consistently to all borrowing costs that are directly attributable to the acquisition, construction, or production of all qualifying assets.’ (Robert Tully May 2000)x It is true entities have the option of capitalizing the borrowing costs but such option is confined to matters confined or covered under IAS 23. Such option is not available under other international accounting standards. Thus regulations prescribed under IAS 23 lacks uniformity in application when compared with other international accounting standards. Therefore it can be said that IAS 23 does not the conceptual framework envisaged by IASB. Darryn Rundell (page 2)xi states ‘These differences could lead to materially different amount being reported in financial statements. The IASB’s constituents would be served better by addressing the issues surrounding the capitalization of interest once only.’ IAS 36- Impairment of Assets Standardization of impairment loss adjustment of assets has opened up vistas of financial statement presentation to a different level where magnitude of effects varies depending upon the size of intangibles with the entities. For example net assets of entities whose majority of assets constitute intangibles are now comparable to their market value and thus their financial statements ease out merger or acquisition deals. Intangibles are no longer amortized. Effectively the companies that used amortization of intangibles over a shorter period of time are likely to be affected more for the best as their earning per share is likely to get a boost. Also amortization processing was not representative of facts and thus used to present unreliable financial statements. Companies could tailor financial statements using amortization as a tool to mould the presentations. Take the case of goodwill. Amortization of goodwill over a predetermined period is representative accounting. ‘Goodwill is for ever. A better argument is that goodwill should not have been amortized.’(Calvin Johnson, page 9)xii Basically the characters of faithful representation and verifiability of financial statements are enhanced because of three fold impact of impairment loss adjustments. ‘Firstly the income statement gets affected by the impairment loss. Secondly the balance sheet is affected in that net equity is decreased by the amount of impairment through revaluation of assets and the change to retained earnings from income statements. In future periods it is expected that stated values of assets will more closely resemble market values, and earning will normally increase as a result of decrease in depreciation expense. Third impairment losses are expected to decrease in size (fewer ‘big baths’), but be reported more frequently, resulting in timely information.’(Rene Hlousek, page 1)xiii It must be understood that impairment write- downs of previously depreciated properties are in fact early recognition of losses on prospective sales of depreciable properties. As such losses are excluded from the current income; it presents a consistent and appropriate treatment of affairs of entity. Impairment of assets also increases the understandability of financial statements as entities do not intend to sell assets to record impairment losses in assets. This type of accounting provides results that are based on the intrinsic values of assets. In fact ‘recording the recovery of non- credit losses in future periods distorts the future earnings and makes the reports less useful for users. Of notable importance is that the fair value of holdings is still provided on the face of balance sheet for available- for- sale securities, thus adding further transparency for users of financial information.’(Melissa Wardell, page 3)xiv IAS 37- Provisions, Contingent liabilities, and Contingent assets The objective and scope of IAS 37 is in conformity with the requirement of characters explained and prescribed in the framework of standards envisaged by IASB. ‘IAS 37 prescribes the appropriate accounting treatment as well as the disclosure requirements of all provisions, contingent liabilities, and contingent assets to enable users to understand their nature, timings, and amount. It guides the preparers of financial statements to decide when, with respect to specific obligation, they should provide for it (recognize it), only disclose information, or disclose nothing.’ (Hennie Van Greuning, Chapter 20)xv IAS 37 enhances faithful representation of financial statements mainly because of its application provides: ‘Information inside the balance sheet: provisions for liabilities and charges, that allow company answer to proper risk. Information outside the balance sheet: notes attached to the financial statements that company must present including all the information that accounting can show a truly and faithful image.’(Naim Afgan and others, page 152)xvi In a way IAS 37 checks the manipulation of financial statements for ulterior motives of entities that may misguide investors and other users of financial statements. It checks unnecessary provisions or creation of hidden reserves as such things would render financial statements as not neutral and therefore unreliable. In this fashion faithfulness is preserved on basis of reliable information. The standard insists upon consistency character of the statements. For example once a contingent liability is recognized it becomes obligatory that ‘an entity should continually assess the probability of the outflow of the future economic benefits relating to that contingent liability. If the probability of the outflow of the future economic benefits changes to more likely than not, then the contingent liability may develop into an actual liability and would need to be recognized as a provision.’(Putra, 14 April 2009)xvii IAS 37 also maintains the faithfulness particularly when liabilities re recognized earlier than those become due. The standard seeks that ‘as soon as the obligating event has occurred, then subject to other conditions being met, a provision must be made immediately.’(Paul Rodgers and others, page 225)xviii Thus IAS 37 not only encourages the employment of characters prescribed in the framework but insists upon the continuity of such characters in the financial statements. Word count for 12 pages: 3127 References Read More