Financial Reporting and Analysis - Conceptual Framework and Financial Statements - Literature review Example

FINANCIAL REPORTING AND ANALYSIS: Conceptual Framework and Financial ments Introduction A conceptual framework provides a model that guides the formulation and tabulation of important financial information of a company in standardised reporting formats, known as financial statements. These statements are not only useful to the management of the company, but also other external users such as equity investors, debtors, internal and external auditors, and customers. It is widely believed that if companies adhere to accounting and financial reporting requirements while preparing their financial statements, the statements can provide a clear and accurate financial picture to the internal and external users. The purpose of this essay is to understand the terminology conceptual framework in the perspective of accounting and financial reporting, justify the belief that financial statements provide comprehensive information about a company that is useful to existing and potential stakeholders, and analyse the general purpose of financial statements while considering the information provided in the key components. Requirement 1 A conceptual framework refers to a methodical layout that contains an ordered sequence of suppositions, rules and approaches. In general, a conceptual framework provides a working mechanism of a concept by breaking it down into segments and specifying regulations regarding each segment (Business Dictionary, 2014). In terms of accounting, conceptual framework refers to the philosophy followed by an accounting and financial reporting standard setting board that would help guide the quality, content, appearance and measurement of financial information about a company’s performance. Such financial information is represented in specified formats called financial statements that can enable users to understand vital statistics of a company’s financial health and take critical decisions about the future. A conceptual framework strives to integrate and assimilate various regulations and guidelines regarding accounting and financial reporting that have developed independently over time, to create a comprehensive and detailed layout (IPSASB, 2013). The formulation of an international conceptual framework for accounting was jointly undertaken by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) of the US in 2004 and is now being pursued by IASB solely. It was initiated with the intention of congregating the many different norms of accounting that independently developed in different countries of the world. Besides, it also intended to improve prevalent accounting and financial reporting practices by modifying them as per requirements and eliminating the ones that are redundant in the modern context (IAS Plus, 2014; FASB, 2006). Based on the embedded philosophies of the conceptual framework, an accounting and financial reporting standard setting board issues new policies relating to deducing critical financial information about a company and presenting the information in an organised fashion that can be assessed and evaluated by the management, investors, debtors and internal and external auditors. As a practical extension of its conceptual framework, IASB introduced the International Financial Reporting Standards (IFRS), a comprehensive accounting and financial reporting standard that enables local and multinational companies to present financial data in a manner that is universally intelligible (IFRS, N.D.). This is especially helpful since a large number of modern globalised companies have operations spanning multiple countries and regions. IFRS is increasingly substituting regional accounting and financial reporting standards, such as US GAAP and UK GAAP, and bringing all the adopting countries on a common platform. The objective of IFRS is to present sound and logical data in a manner that is relevant to all the parties related to a company. For this, IFRS routinely introduces guidelines that are aimed at increasing financial transparency in business, while simplifying tabulated data for ease of use. One of the most important concepts of IFRS is capital maintenance. It is a conception that acknowledges profit as the amount left after removing the capital invested at the beginning of the period. In other words, capital is said to be maintained when the capital invested at the beginning of a period and the costs associated with this investment are reclaimed at the end of the period. Such costs may include depreciation. Some of the capital maintenance measurement models mentioned in the IFRS are present value model, current cost accounting and net realisable value (B. Elliott and J. Elliott, 2013). The concept of capital maintenance is covered under the “Framework for the Presentation and Preparation of Financial Statements” of IASB. It clearly defines profit as the value left at the end of the year after isolating the value equal to the net assets that were present at the start of the year, before adjusting for dividends and contributions. Capital maintenance is automatically reflected in the financial statements prepared in accordance to IFRS. Financial statements segregate the financial information of a company under key parameters such as assets, liabilities, debt, equity, revenues, cost of sales and profits. They clearly distinguish between return on capital, or profits earned; and return of capital, or repayment of the principal amount. This completely prevents a company from manipulating its financial information and misrepresenting its income stream as profits in order to lure in more investors. It also helps investors to clearly assess the profitability of a company, payback period and return on investment. Thus, financial statements provide comprehensive information about the reporting entity that is useful to all existing and potential stakeholders. Requirement 2 The general purpose of financial statements is to present data regarding a company’s financial health and financial performance in a standardised format that is easily understandable. This is primarily because there are multiple parties that hold interest in the financial data of a company, all with different purposes. Some of these parties include the equity investors, debtors, board of directors, and customers. Whenever there are conflicts of interest between the different parties, there are always chances of manipulation of data to mislead one party by another. To prevent such issues and to provide an accurate, unbiased written account of the company’s activities, financial statements follow specific structures that have been designed keeping in mind the different needs of different parties. As a result, there are different financial statements prevailing, such as Statement of Comprehensive Income, Balance Sheet, Statement of Changes in Equity and Statement of Cash Flow. Each of these statements providing a set of key information that is of specific interest to different parties (Accounting-Simplified.com, 2013; EFRAG, 2009; Tesco, 2013). For instance, the Statement of Comprehensive Income lists down the annual earnings and expenses of a company, scrutinising expenditures made on marketing, office administration, salaries and wages of employees, raw materials, cost of sales, repayment of debt; and income generated from goods sales, rental income, and intellectual properties such as patents and copyrights. Evidently, this is a statement that records information not for the investors and debtors, but for the management of the company, to help them allocate material and financial resources more effectively and monitor the utilisation of these resources (Ready Ratios, 2014a; McGraw-Hill, 2007). Balance Sheet is a comprehensive document that records a multitude of information, such as the current and fixed assets; current and fixed liabilities; equity structure of the company; and retained earnings, dividends and reserves. Of these, equity structure, retained earnings, dividends and reserves are important to both the management of a company and its equity stakeholders. They convey critical information such as the return on investment to equity investors, the cash surplus with the company and the amount of profits reinvested into business. Current assets and current liabilities are of prime importance to the management and debtors, providing information on the ability of the company to pay off immediate liabilities, such as loan interests. Fixed assets and fixed liabilities portray the long-term strategic advantages and disadvantages of the company and are helpful in growth projections. They are thus useful to the management and equity investors (Government of Western Australia, 2013; Basu, 2014). Statement of Changes in Equity provides critical information such as net income, dividends paid, shares issued and strategic investments. This statement is thus valuable for identifying the operational efficiency of the company, aggressiveness in business and the performance of the capital investments made. These information are helpful both for the management of the company and the equity investors, since they would help in capital allocation; and return on investment and return of capital calculations. However, they are not of any particular use to debt investors since they would receive fixed monthly interest for their investments, irrespective of the financial health of the company (Ready Ratios, 2014b). Statement of Cash Flow provides the circulation of money in the company under three categories, cash inflow and outflow from day to day operations, cash inflow and outflow from purchase and sale of investments, and cash inflow and outflow due to raising capital and paying dividends and interests. This is a strategic tool to track the exact flow of invested capital and is critical to measuring the short-term financial prosperity of the company. It helps in identifying surplus cash and comparing year on year capital performance. The statement is thus valuable to management for taking crucial strategic decisions, and for the debtors to assess the ability of the company to pay its debts. To equity investors however, this statement holds little value as it is too elaborate and contains information that do not entice them (Dinu, 2013; Ministry of Corporate Affairs, 2014). Conclusion The conceptual framework of IASB has helped create the IFRS, a comprehensive accounting and financial reporting standard that enables local and multinational companies to present financial data in a manner that is universally intelligible. Under the mandates if the IFRS, financial information must be tabulated as per the standardised formats, such as Statement of Comprehensive Income, Balance Sheet, Statement of Changes in Equity and Statement of Cash Flow. Each of these statements providing a set of key information that is of specific interest to different parties. The primary concerns of IFRS are to ensure transparency in the company’s operations and the protection of current and potential debt and equity investors of the company. For this, it has introduced the concept of capital maintenance, which separates return on capital and return of capital by defining profit as the residual amount that is left after removing the initial capital invested and costs such as depreciation, from the annual income. To assess capital maintenance, IFRS has introduced measurement models such as present value model, current cost accounting and net realisable value. Capital maintenance is also reflected upon the financial statement formats of the IFRS. The different financial statements provide a range of key financial information that are of specific interests to different parties. For example, Statement of Comprehensive Income is primarily useful for the management of a company, Balance Sheet is primarily useful for the management and equity investors, and Statement of Cash Flow is primarily useful for the management and debtors. Reference List Accounting-Simplified.com, 2013. Purpose of Financial Statements. [online] Available at: [Accessed 22 January 2014]. Basu, C., 2014. What Are the Three Most Important Metrics in the Balance Sheet? [online] Available at: [Accessed 22 January 2014]. Business Dictionary, 2014. conceptual framework. [online] Available at: [Accessed 22 January 2014]. Dinu, A., 2013. Components of the Cash Flow Statement and Example. [online] Available at: [Accessed 22 January 2014]. EFRAG, 2009. THE NEEDS OF USERS OF FINANCIAL INFORMATION. [pdf] EFRAG. Available at: [Accessed 22 January 2014]. Elliot, B. and Elliot, J., 2013. Financial Accounting and Reporting (sixteenth edition). London: Pearson. FASB, 2006. Conceptual Framework for Financial Reporting. [pdf] FASB. Available at: [Accessed 22 January 2014]. Government of Western Australia, 2013. Components of a Balance Sheet. [online] Available at: [Accessed 22 January 2014]. IAS Plus, 2014. Conceptual Framework — Comprehensive IASB project. [online] Available at: [Accessed 22 January 2014]. IFRS, No Date. Conceptual Framework. [online] Available at: [Accessed 22 January 2014]. IPSASB, 2013. The Conceptual Framework for General Purpose Financial Reporting by Public Sector Entities. [pdf] IPSASB. Available at: [Accessed 22 January 2014]. McGraw-Hill, 2007. Comprehensive Income. [online] Available at: [Accessed 22 January 2014]. Ministry of Corporate Affairs, 2014. Cash Flow Statements. [pdf] Ministry of Corporate Affairs. Available at: [Accessed 22 January 2014]. Ready Ratios, 2014a. IFRS Disclosure Guide 2012. [online] Available at: [Accessed 22 January 2014]. Ready Ratios, 2014b. Statement of Changes in Equity. [online] Available at: [Accessed 22 January 2014]. Tesco, 2013. Tesco PLC Annual Report and Financial Statements 2013. [pdf] Tesco plc. Available at: [Accessed 22 January 2014]. Read More