Risk, Regulation and Compliance - Coursework Example

Risk, Regulation and Compliance Introduction It is essential for financial services to create levels of trustand confidence in order to maintain sales and profitability. There are different ways of protecting consumers including strong rules, principle based protection, outcomes based and judgmental approaches to consumer protection (Ramachandran and Kakani 2005). Rules versus principles approaches are the heart of the current debate on how accountants should approach their duties in ensuring the validity of financial statements and records. The debate relates to the issue of whether we need general principles to prepare financial records and statements, or whether accountants should follow extensive rule framework which they should comply with when serving external clients with financial statements. After the recent financial scandals, the Securities Exchange Commission (SEC) proposed some objective oriented principles through the Sarbanes-Oxley Act of 2002 (Ramachandran and Kakani 2005). According to SEC, asset/liability approach which deals with fair values is inconsistent with principles should management should have guidance on how to make their judgments. According to the public perception, accounting standards in the US are more rule-based. By following rules, accountants will declare financial statements according to the law and regulations (Duska, Duska and Ragatz 2011). Under the principle based approach, the accountants are required to apply their sound judgment in preparing the financial statements. In response to the recent accounting scandals at Enron and Worldcom, many analysts have pointed out that the current rule-based accounting is outdated. However, many accountants favor the use of rule based accounting in order to escape liability or confrontation with clients when their judgment is incorrect and inconsistent (Duska, Duska and Ragatz 2011). Financial reporting scandals and failures have decreased stakeholders’ confidence in the financial markets. The management of Enron deliberately misled investors by adjusting the numbers in their financial reports. To claw back investor confidence, the US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) signed an agreement to form a Conceptual Framework that will guide financial reporting. The principle based approach includes accounting fundamentals like true and fair view, going concern and substance over form with the appropriate level of specialty (Beattie, Fearnley and Hines 2011). Accounting to the true and fair view, the financial statements will comply with this standard when presented in a fair manner, including the financial performance and changes in the financial position of the accounting entity (Duska, Duska and Ragatz 2011). Principle based approach leaves some room for professional judgment unlike rule based accounting that is strict on following well-documented rules. Generally Accepted Accounting Principles (GAAP) which is rule based system has certain advantages and shortcomings which should be compared with International Accounting Standards (IAS). The problem which arises in the use of principle-based approach is the guidance in order to achieve comparability and consistency of financial statements. For instance SFAS 133 which deals with accounting for derivatives and hedging activities requires all derivative assets to be reported at fair value (Chalmers and Godfrey 2007). In this case, the fair value can be the bid price, the asking price or an average of the bid and asking price thus a rule is essential since reporting entities will always manipulate their derivative contracts to attain favorable performance reporting (Chalmers and Godfrey 2007). For instance, IAS 17 which is principle based approach states that that the inception of lease, the minimum lease payments at present value should be equivalent with the fair value of the asset. According to SFAS 13 which is rule based approach, the present value at the beginning of the lease period of the minimum lease payments should be equal or more than 90 percent of the excess of fair value of the leased asset to the lessor at lease inception (Jeffery 2011). Advantages and disadvantages of principle based approach According to the SEC, principle-based approach will have certain characteristics like objectivity of the standard and sufficient detail of how the principle can be applied on a continuous basis. The principles clearly outline the objectives of each standard thus percentage tests that allow financial engineers to achieve technical compliance with the rule-based approach while avoiding the intentions and objectives of the standard will be eliminated (Jeffery 2011). The principle based approach will serve the needs of the public and business community by explaining the rationale of the key judgments made by the accounting professionals. Rule-based approach is complex thus principle-based approach will provide the necessary flexibility to deal with new and emerging accounting concepts. Accordingly, the true and fair value should be the cornerstone of the accounting profession thus professional judgment should be done according to the set accounting principles (Jeffery 2011). On the other side, I believe that principle-based approach suffers from certain disadvantages since its limited guidance may lead to enforcement difficulties. The principle based approach may not deter aggressive and opportunistic behavior of the reporting entities. For instance, it will be difficulty to prove the decisions of an accounting entity that make opportunistic decisions without adequate measures and disclosure of the rules followed to make the decision. However, the principle based approach will have to make efforts to increase consistency, increase the verifiability of accounting reports and reduce opportunities inherent in earnings management through flawed judgmental reporting (Jeffery 2011). Advantages and disadvantages of rule-based approach According to proponents of the rule-based approach, rules provide a detailed approach on financial reporting which is authoritative and enforceable to all reporting entities. Additionally, rule-based approach provides greater comparability and deters creative accounting methods. The proponents add that this approach is only complex depending on the underlying reporting entity and will provide equal access to all stakeholders depending on the emerging accounting scenarios (Brigham and Ehrardt 2011). On the other hand, rule based approach creates complexity and prevents reporting entities for keeping abreast with changes in accounting profession and operating environment. Rules are often translated with major difficulties and are not comprehensive enough to cover all accounting reporting scenarios (Jeffery 2011). Examples of differences IFRS require that leases to be capitalized as both an asset and liability when the lease agreement transfers substantial rewards and risks to the lessee. According to SFAS 13 which is rule based, the length of the lease should be equal or more than 75 percent of the useful life of the asset or the present value of the minimum lease payments should be equal to or more than 90 percent of the fair value of the particular lease asset. The rule based approach in this case is clear and variable. Additionally, US GAAP which gives the guidance on government grants requires the grants to be recognized as income over the periods which match the related costs to grant them (Narayanaswamy 2008). ISA 20 treats the grant as income over the useful life of assets but it does not direct on how to use to account for the grant if it is given for the purchase of land which appreciates in value. Another clear example is the definition of subsidiary which is Enron related example. According to US definition, a subsidiary is based on the ownership and control of more than half of the voting shares of the particular entity while IASB principles define a subsidiary as an entity which another entity has the power to control. In this case, it is clear that rule based approach is complex in definition and application in financial reporting (Narayanaswamy 2008). Another example of advantages of principle based approach is ISA 19 which deals with pension accounting which is flexible enough to allow the reporting entity to select an alternative of recognition of actuarial gains and losses. For instance, gains and liabilities can be recognized on the same basis over the period of time or immediately in the income statement or by adjusting the equity of the reporting entity (Benson 2006). Outcome and objectives approach of consumer protection Outcome based approaches to consumer protection include moving away from the detailed rule to broad principles and standards which all reporting entities need to meet. This has been the feature of the regulatory environment in the UK since 1990s and is currently the recommended approach to financial reporting (Narayanaswamy 2008). This approach includes the behavioral standards like integrity thus expressing the reason for making a reporting decision. Outcome based approach is applicable in broad circumstances and changing scenarios in the accounting profession. This approach is objective since it focuses on risks and includes flexibility in reporting. It promotes a reporting behavior which is consistent with the objectives of regulation and will entail considering the purpose behind the set regulatory rules rather than the detailed provisions of the accounting and reporting rules. However, this approach only works best where good relationships between the reporting entities and regular exists in order for the management to apply their own sound judgment in reporting (Ramachandran and Kakani 2005). Conclusion Rule based accounting approach relies on detailed rules which the reporting entity must follow. principle based accounting follows broad accounting standards and allows the management to exercise their own sound judgment in reporting. Rule based accounting will provide room for financial engineering and creative accounting thus failing to provide the “true and fair view” of the financial reports. Accordingly, the regulators must be willing to accept numerous judgment-based outcomes from the reporting entities. Principle-based accounting is based on a conceptual framework which explains the importance of the standard and has no bright-line provisions. In my view, a principle based approach of accounting reporting and outcomes based regulation will improve the market confidence. Bibliography: Beattie, V., Fearnley, S and Hines, T. 2011. Reaching key financial reporting decisions: how directors and auditors interact. West Sussex. John Wiley & Sons. Benson, G. 2006. Worldwide financial reporting: the development and future of accounting standards. Oxford. Oxford University Press. Brigham, E and Ehrardt, M. 2011. Financial management: theory and practice. Mason. Cengage Learning. Chalmers, K and Godfrey, J. 2007. Globalization of accounting standards. Cheltenham. Elgar. Duska, R., Duska, B.S and Ragatz, J. 2011. Accounting ethics. Oxford. Blackwell Publishers. Jeffery, C. 2011. Research on professional responsibility and ethics in accounting. Bradford. Emerald Group. Narayanaswamy, R. 2008. Financial accounting: a managerial perspective. New Delhi. PHI Learning. Ramachandran, N and Kakani, R. 2005. Financial accounting for management. New Delhi. McGraw-Hill. Read More