Why Principles-Based Standards Require a Conceptual Framework - Assignment Example

Name of institution Student name Student ID number Subject title Code Case study 1: Revisiting the conceptual framework Question one: Explain why principles-based standards require a conceptual framework. A conceptual framework is a system comprising of ideas and objectives that help in the creation of a set of consistent rules and standards. In the accounting field, the set of rules and standards define the scope and functions of financial accounting as well as financial statements. The conceptual framework considers both the theoretical and conceptual aspects of financial accounting and then provides a consistent foundation that guides the development and implementation of accounting standards. The FASB and IASB are standard setting bodies that rely on conceptual frameworks to develop principle-based financial accounting and standards (G., & Crook, 2005) The conceptual framework provides the accepted accounting principles (GAAP) which act as a reference for the evaluation of established accounting practices and the development of new practices. The conceptual framework outlines how financial transactions should be valued and reported to provide useful and important information to the users so that they can make informed decisions. A conceptual framework for principle-based standards of accounting provides a base for resolving the disputes that might arise in accounting due to different individual views and perception. Without a conceptual framework, it would be difficult for setters of accounting standards to reach a consensus as the process would be based on the concepts of each member of the body. It would even be more difficult since the membership of the standard setting body changes over time, causing inconsistency of the set accounting standards. The Financial Accounting Standards Board initially faced difficulties in agreeing on standards, and consequently the members of the board developed a conceptual framework to guide them in setting standards. Question two The importance of the IASB and FASB to share a common conceptual framework The IASB and FASB have a common goal to have their principle-based standards share a common conceptual framework. The common conceptual framework will ensure that the accounting principles will be based on economic concepts and not on arbitrary conventions. The framework will be dealing with some issues, and it will be built on the original FASB and IASB frameworks. It will also consider the new developments that have occurred since the two standard-setting boards were formed. This conceptual framework will help the bodies in identifying the issues that repeatedly occur in standard-setting projects. The two boards have several projects that they conduct jointly or in tandem and so they ought to have a common conceptual framework that would help them in converging their principle-based standards and achieve common goals. As a result of the convergence of the standards of the two boards, they will be able to focus on key issues that feature in different projects and address them in a comprehensive manner. The boards will have a broader and better way to view the implications of projects so as to be able to develop principle-based standards in financial accounting and reporting as well as guidance on the same. Question three The importance of a conceptual framework to several parties A conceptual framework is helpful to various parties in financial accounting and financial reporting. Firstly, the conceptual framework is extremely important to the setters of accounting standards such as the FASB and IASB. These boards rely on the established framework in the development of new accounting standards and also in the evaluation of the existing ones. This enables the boards to create an environment of fair and true accounting concepts and enhance consistency of the accounting standards. As a result, there is efficiency and effectiveness since the conceptual framework provides the pathway for decision-making and conflicts of interests due to personal preferences are eliminated. In the absence of a conceptual framework, the process of standard setting is flawed haphazard, causing ambiguity in the rules and regulations governing financial accounting and financial reporting. If confusion would arise in the accounting functions due to the inconsistency of the set standards, then the credibility of the boards would be questioned. Hence, I can say that the FASB and IASB are the greatest beneficiaries of the conceptual framework. Another party that benefits greatly from the conceptual framework of financial accounting and reporting are the preparers of financial statements. Due to the globalization of the accounting function, accounting practitioners rely on generally accepted accounting principles in the preparation of financial statements for national and international organizations. The financial statements are prepared by the set guidelines so that they can conform to the conceptual framework. This provides a common approach for determining the financial performance of an organization, enhancing fairness and transparency. Without a standard conceptual framework, it would be difficult for accounting professionals to prepare financial statements and reports, and the whole process would be flawed due to ambiguity and personal interests of different groups. Other parties that benefit from the conceptual framework are investors, lenders, and auditors. These stakeholders need to inspect the financial statements of a company so that they can make critical decisions concerning investment, lending and formation of an independent opinion respectively, concerning the company. In my opinion, the setters of accounting standards benefit from a conceptual framework the most, followed by preparers of financial statements and then other stakeholders such as investors, lenders, and auditors. Question four Cross-cutting issues Cross-cutting issues refer to troublesome issues that arise in the boards repeatedly during times of standard-setting projects. To address these issues holistically, there is a need to have a common conceptual framework that handles all the aspects of the issues as it has proven difficult to tackle them using a single framework of either of FASB or IASB. Examples of such cutting across issues that arise in standards-setting projects include the recognition of elements included in the financial statements, how to measure the elements as well as the concepts and maintenance of capital. The proposed common conceptual framework will seek to promote international harmonization of these concepts to ensure more consistent and principle-based accounting standards. Case study 2: The trend toward fair value accounting Question one The fundamental problem of using historical cost approach under US GAAP The fundamental problem with financial statements based upon historical cost measurement principle used under US GAAP. The US GAAP are developed by the Financial Accounting Standards Board (FASB) which sets the accounting standards. The GAAP provides the guideline that should be followed by corporations and analysts in financial accounting. This approach is based on the historical cost measurement principle However, some accounting professionals have argued that the US GAAP is extremely flawed. The fundamental problem of the US GAAP is that the system focuses on the market value of a company rather than its fair value, leading to misrepresentation of financial information about an organization. Evidence to support this claim is that the market value of the companies that public trade on the New York Stock Exchange is approximately five times the fair value of their assets. For financial statements to reflect relevance and usefulness, fair value accounting approach should be used in preparing the statements. The fair value approach would produce financial statements that provide a clear picture of the real economic situation of the subject company. The US GAAP approach of historical cost puts more emphasis on reliability than on relevance. However, relevance should be a top priority of accounting standards since it influences the decision-making process of the parties who rely on the information contained in the financial statements. It is the relevance of financial information that makes it reliable for investors and other interested parties. If the information is relevant to the fair value of the company, then it should be presented in a manner that depicts faithfulness and verifiability(Fargher, 2001). Question two Accounts must reflect economic reality The principle that accounts must reflect economic reality implies that the information contained in the financial statement should be true and faithful to show the actual value and financial performance of a company. The stakeholders of a company such as shareholders, lenders, and potential investors rely on the information provided in the financial statements to make informed decisions. For financial information to reflect economic reality, it should be both relevant and reliable so that the stakeholders can have confidence in the information. Deviation from the reflection of economic reality may lead to uncertainty on investors and make them lose trust on the information. To ensure that the accounts of a company, the directors and accounting professionals should adopt accounting policies that portray representational faithfulness so that the interested parties that rely on the presented financial information are not misguided by falsely misrepresented information. I believe that the ultimate objective of any company should be to use an accounting system that is objectives-oriented to enable the company and auditors to deliver financial numbers based on economic reality and providing comparability with the market needs. Accounting professionals should not concentrate on achieving technical compliance with cumbersome rules that might make them compromise the faithfulness of the information and misguide investors and other parties. The financial statements should enable all the parties to view the company's financial performance through the same eyes that the management sees it. Accounting professionals should report financial information as it is rather than attempting to "create" reality into the information. Question three How to measure economic reality Economic reality implies that the information contained in the financial statements is fair and has representational faithfulness. The economic activity of the company is represented by its periodic financial statements such the balance sheet, income statement and the statement of cash flows. Economic reality can be measured by the extent to which the accounting entity uses the fair value of accounting elements such as assets, liabilities, equity among other elements. For these elements to reflect economic reality, they should be measured at their fair value that portrays their current market price. The fair t value accounting approach is a rational and unbiased approach that takes into consideration factors such as depreciation, supply, demand and level of utility. It also incorporates some subjective elements such as risk characteristics and even the cost and return of capital. The fair value is viewed as a certainty of the market value of an asset or liability as at the measurement date. Financial statements prepared using the fair value of the accounting elements provides investors and other interested parties with up-to-date information that contains the current value of items such as assets and liabilities rather than historical cost. Hence, it can be argued that to assess the economic reality of the financial information provided by a company, it is prudent to examine it financial elements in respect to their fair value that has a high degree of relevance and reliability. The relevance and reliability increase the degree of informed decision making for the interested parties. Question four What is reliability in accounting? According to the FASB Conceptual Framework, Concepts Statement No.2 states that reliability is the quality of information that the information contained in financial statements is free from errors or bias, and it presents what it purports to represent in a faithful manner. It assures the users of the information that it has representational quality, through verification. Therefore, the main elements of reliability are verifiability and representational faithfulness. Reliability in accounting rests on the use of fair values that are arrived at through estimation since they cannot be directly observed in the active markets. The fair value measures of the accounting elements such as assets and liabilities are perceived to be sufficiently reliable by the users such as shareholders, lenders, and investors in making informed and realistic decisions. Reliability, therefore, calls for the accounting professionals to observe transparency and faithfulness when preparing financial statements so that they are materially correct. If some elements of the information are significantly misstated or omitted, then the reliability of the information contained in them reduces greatly as the users of the information lose confidence in them. The key accounting concepts and principles that foster liability of accounting information include neutrality, faithful representation, completeness, prudence, and objectivity. The accounting professional should, therefore, present information that can be sufficiently verified and justified. Case study 3: Disclosure of environmental liability Question one Estimating environmental liabilities Environmental liability refers to an obligation to incur a future expenditure due to the past or present use, manufacture, the release of an asset or activity whose effects adversely affect the environment(Adshead, 2005). Failure for a company to disclose the environmental liability in the determination of the fair value of its assets can lead to misrepresentation of its financial performance and value and hence misguide the users of its financial information. Environmental liabilities arise from several sources such regulations, government statutes or ordinances, which can be enforced by either the public agencies or suit by private citizens. The liabilities include compliance liabilities, remediation liabilities, criminal fines and penalties, compensation liabilities and natural resource damages. The environmental liabilities can be estimated in several ways. One estimation method is the most likely value approach, in which the mostly likely cost of scenario to occur is taken as an estimate. Another approach is the range of values approach, whereby a range of values is developed and probabilities assigned to them. The value with the highest probability is taken as the estimate. The other method, though sophisticated to use, is probabilistic statistical models. It is advantageous to use this approach since it provides for more flexibility and in-depth statistical analysis of costs and their variability. Question two Aspects of the requirements used by the US Companies to defer recognition of environmental liabilities The US Financial Accounting Standards Board (FASB) required companies to account for environmental liabilities on the assets that are retired from use by the companies. However, this requirement by the US FASB was conditional. The companies were only required to account for the environmental liabilities if they could reasonably estimate the fair values of the assets. The timing of asset retirement was also not specific as companies have their timing of their assets' life span. The conditional aspect of the provision made the companies defer their environmental liabilities indefinitely through mothballing of contaminated properties. As a result, the companies opted to postpone the recognition of their obligations due to the absence of anticipated litigation. This was because there was no law that forced companies to make provisions for environmental liabilities and no action would be taken against them. The FASB had to make a clarification on the issue, by providing a clear and concise interpretation of the requirements. The standard-setter stated that the US companies had a legal obligation to make provision for environmental liabilities as well as any other liability that is associated with disposal or retirement of an asset or facility. This requirement applies even in cases where the timing of the asset retirement or the settlement method is uncertain. The clarification had to have examples to for illustration such as ruling out that company property cannot be mothballed without provisions for eventual disposal costs, and reserves should be made in advance before the retirement of the asset in question. As a result, the US companies can no longer defer the recognition of environmental liabilities in their financial disclosures as the requirement is legally enforceable. Question three (a) Effects of recognition of environmental liabilities on net profit Environmental liabilities are mostly based on estimates as it is difficult to know their exact fair value due to their uncertain nature of occurrence. The liabilities are arrived at through estimation of both direct and indirect costs such as clean-up and administrative costs respectively. These costs can be recognized in the income statement as accrued expenses. The general effect is that the net profit of the company for the current year does not change. This because no expense has occurred until the reserved cash has been used in future for the restoration of the asset. The net profit for the company in the future years is likely to drop, but only if the anticipated expense has occurred. Effects of recognition of environmental liabilities on the cash flow in the current and future years The amounts of cash flow resulting from the retirement of an asset to cover the actual cost as well as covering the retirement obligation vary greatly and can only be estimated. This because some assets such as manufacturing plants have long lives and getting the fair value of the retirement liabilities is a difficult task. However, the cash outflows are not likely to increase in the current year since no actual payment of the provision has been made. Then the actual payment occurs, then the cash flow are likely to increase by the amount paid and the amount realized by the company upon the retirement of the asset. The accounting professionals need to attach disclosures alongside the cash flow statement showing the probability of changes in cash flows taking into consideration factors like inflation rates, labor costs and changes in technology that affect cash flow materially. Question four The importance of recognition of environmental liability by companies Recognition of environmental liabilities in the financial statements of a firm is important for the shareholders as it provides them with an accurate and complete environmental disclosure. Otherwise left, the companies might leave the environment contaminated due to industrial and commercial misuse and ignorance and can lead to adverse impacts on the human lives. Another importance of recognition of liabilities is that the companies can have improved relations with the communities and government agencies and fewer costs and time are spent on remediation. Also, the company's tolerance for uncertainty greatly increases due experience gained in estimating liabilities. Of equal importance is the valuable information from historical remediation costs, which can be used to predict future trends of liabilities for new sites and projects. The sufficiency of disclosure of environmental liabilities is limited because the fair value of the liability is arrived at by estimation. The uncertainty about the timing and valuation of asset retirement or disposal of a manufacturing impairs the recognition of the environmental liabilities and can consequently result in inaccurate and misguiding information. Reference Adshead, J. (2005). Environmental Liabilities. Environmental Law Review, 7(4), pp.300-301.Bullen, H. G., & Crook, K. (2005). Revisiting the concepts: A new conceptual framework project. Financial Accounting Standards Board. Fargher, N. (2001). Management Perceptions of Fair-Value Accounting for all Financial Instruments. Australian Accounting Review, 11(25), pp.62-72. Read More